The use of leverages is one of the most important and commonly sought after features in crypto trading. With the establishment of centralized exchanges, trading on leverage has become more and more popular, despite the fact that the crypto market already displays high volatility.
Just like in traditional finance, traders take on leverage either to simply borrow money to increase their purchasing power, or to exploit different kinds of financial derivatives, like futures and options.
The leverage ratios have also been increasing from 3x, 5x to more than 100x. Higher leverage means higher risks, but as shown by the growing volumes of leveraged trading witnessed by most CEXs, this is a danger aggressive traders are willing to undertake, in pursuit of higher returns.
Instruments featuring leverage in the DeFi space include margin trading, perpetual contracts, leveraged tokens and options.
"Leveraged Trading", or “Margin Trading,” means borrowing assets to long or short underlying crypto-assets, using one's own assets as collateral for borrowing.
Margin trading allows traders to use greater capital, increasing their positions with relatively little underlying capital. Essentially, margin trading amplifies trading results so that traders can realize bigger profits on successful trades. The catch is that if the value of the collateral falls below a predetermined threshold, their position gets liquidated. (Unless they provide more collateral, of course.)
Lenders meanwhile earn interest for allowing traders to use their assets.
In centralized markets, the borrowed funds are usually provided by an intermediary, such as centralized exchanges or brokers. In DeFi, funds are often drawn from liquidity pools, whose contributors can earn an interest based on utilization.
Borrowing/lending and trades are all anonymous but transparent transactions, aligned with the rules pre-defined in smart contracts.
A closer look at how the leverage works in margin trading
Suppose you are longing ETH 3x in margin trading, but feel reluctant to adjust the exposure from time to time.
You are holding $100 USDC, borrowing another $200 USDC and trading for $300 ETH in order to take the desired ETH long position. The leverage level is $300/$100=3x.
If the price of ETH rises by 20%, your profit will be $300(1+20%)-$300=$60. You are safer from being liquidated and the real leverage level is decreased to $360/($360-$200)=2.25x.
If the price of ETH drops by 20%, your loss will be $300(1-20%)-$300=-$60. You are in a more dangerous position as far as liquidation is concerned and the real leverage level is increased automatically to $240/($240-$200)=6x.
Therefore, though you may assume that you are taking constant leverage by doing a fixed 3x margin trading, the real-time leverage is constantly changing. Please check here how leverage changes according to the price movement.