Why Margin Trading And Leverage Is Dangerous [Especially In Crypto]

The majority of traders lose money. 

This is the case in both crypto and traditional financial markets.

Now add margin and leverage to the mix and you will lose even faster 

This is because the house magnified its advantage against you. 

Learn what this means and why margin and leverage is so dangerous.

Quick Takes:

• Margin and leverage are advanced trading tools that allow for more profit opportunities and multiplied risk-reward.
• Among their countless risks, lack of control is the crucial one. Leverage and margin traders don’t own most of the traded tokens. They neither control the exchange, which could trade against to liquidate their positions.
• Leverage trading isn’t sustainable to replace investing/spot trading completely. Despite several successful trades, you’re still one bad streak away from making excessive losses, if not going broke (see cross margin).

The Subtle Difference Of Crypto Margin Trading vs Leverage

Both margin and leverage are tools that can increase profits both for traders and exchanges. It involves borrowing money (cryptocurrency) with an initial amount as collateral. This allows both to profit from different market positions and magnify profit/losses.

Margin and leverage are related in that the former is required for the latter. Since most crypto loans are collateralized lending, you need an initial amount to access leverage, also called "initial margin."

They’re different because margin trades don’t always involve leverage. Examples of this are short positions to profit when crypto prices move down:

• Before a downtrend, borrow 1 Bitcoin and sell
• After it falls, buy 1 Bitcoin to repay the loan and keep the difference as profits

If it goes sideways or up, traders have less time before repaying. They might add collateral (or margin) to extend the short, but Bitcoin holders can still terminate the loan anytime.

Margin works as insurance, allowing traders to access advanced tools, one of which is leverage. It’s a risk-reward multiplier that allows trading more than what you own. Typically only centralized exchanges (CEXs) offer this as it requires deep liquidity.

Here’s how different leverage ratios work with an initial margin of $1,000:

• 2:1 leverage allows access to another $1,000 ($2,000 total). If $2,000 devalues by over 50%, it’s liquidated (position closed and initial $1,000 lost).
• 5:1 leverage controls $5,000 with liquidation occurring below 20% or <$4,000
• 10:1 accesses $10,000 at the risk of losing the entire $1,000 with a +10% price decline.
• 100:1 allows $100,000, but it only takes 1% to return $99,000 and lose the initial $1,000. Often within minutes.

A 10% price increase means profits of $200 for 2x, $500 for 5x, $1,000 for 10x, and $10,000 for 100x versus a non-leveraged $100.

The default type of leverage trading has a higher risk of liquidation but losses capped at your initial amount— also called isolated margin. Cross margin uses your entire account’s funds to keep your leverage position open. It can lose a lot of money, but if the trend reverses in your favor, you can avoid liquidation and have higher chances to profit, but only for the amount you set.

CEXs have separated margin accounts to limit risk, so even if you lose everything on cross-margin leverage, it won’t spend your spot balance.

Biggest Risks Of Margin and Leverage Trading

These risks have dissuaded many from ever again trading with leverage. Whether you should use it or not depends on your experience and risk tolerance. Debt is just a situational tool that can speed up profits and is largely unnecessary.

These aren’t meant to discourage margin/leverage trading but give you a better answer on when (or not) to use them.

Asymmetric Risk-Reward

When trading for (negative) asymmetric risk-reward, you’re guaranteed to end up losing. Positive asymmetry, however, is a tendency to win despite short-term uncertainty.

When you margin-trade to short Bitcoin, your upside is limited to 200% ROI with Bitcoin falling to zero. But there’s no limit to how much prices can increase, and your profit margin gradually reduces from maintenance fees. You can limit risk with smaller positions, but if it goes up, holders can earn well over 200%. Reward asymmetry.

Short traders can bypass this using leverage. But you’re further reducing your error margin. Stop-loss orders can help but also reduce the opportunity to profit if prices revert and reach targets.

Leverage offers positive reward and negative risk asymmetry. You’re more likely to exit from automatic liquidation than take profits (especially over 5x leverage). To increase your probability, you’d need to increase your margin and what you’re willing to lose (reduced reward).

CEX Risk

CEXs provide enough liquidity to support margin/leverage trading. But CEXs also lose funds all the time. It’s the last place where you’d want to store your coins for several reasons:

• Fees and ToS can change anytime without notice
• They lack transparency and/or Proof Of Reserves
• Account freezes and withdrawal suspensions are common
• They’re the no.1 cyber-attack target. A sizable amount of user cryptocurrency is in online hot wallets
• It’s not clear how much crypto is lent/borrowed/illiquid

CEXs are still the go-to place for margin trading because of limited orders, fees, and trading tools. Margin/leverage are short-term tools that involve more orders and fees. It’s not practical to move coins in and out every time you close positions.

But if you keep them there, one day they might not be.

Lower Liquidity

CEXs boast of having deep liquidity, although it’s not clear how much. Most of them have been caught faking trading volume. Not only this encourages trading illiquid/inactive tokens but can move prices just enough to liquidate leverage traders— also known as crypto scam wicks.

Is it the inherent volatility of crypto or someone manipulating prices? The more leveraged positions and the higher, the less obvious. A 0.5% price pump might be enough to trigger stop losses that further trigger liquidations and wipe out everyone within minutes.

Scam wicks only appear on the manipulated/volatile exchange. The plain answer is not to trade there, but obviously, it can happen in any CEX. Traders can have enough public data on intelligence platforms (Messari, Glassnode) to take advantage of leveraged positions.

Implicit Risks

Whether you lose or profit from leverage or margin trading, different psychological “risks” appear. These lead to bad decisions that holders can usually get away with. But leverage traders don’t have that tolerance because of the stakes. The biggest challenges are:

• Impulsive Trading/Action Bias: Fast feedback is a key component for motivation… and addiction. It might feel like trading more is the answer to any market situation, when instead patiently waiting can be just as profitable but safer. Fees aside, more trades mean higher chances of making mistakes, especially when you feel confident that you can make it back overnight because of leverage.
• The Gambler’s Fallacy: Fast, wrong feedback is the recipe for disaster. Trading systems are probabilistic, so there’s a chance you do everything wrong, win a lot of trades in a row, and start trusting a bad strategy. Whether it’s a streak of profits or losses, there’s the illusion that more profits will follow from recent experience.
• Emotional Trading: The longer you spend watching the markets, the easier it is to think reactively. Besides feedback, another reason is loss aversion. That’s to underestimate profits, miss the opportunity to lock in current ones, and not accept losses by trying riskier trades to fix things.

• Overreliance: Also linked to the gambler’s fallacy, it might become second nature to margin or leverage trade every time. You might try to catch both spikes and dips with leveraged longs or shorts. But if you can’t profitably trade with basic tools like market or limit orders, leverage is only going to worsen the problem.
• Hindsight/Seller’s Remorse: Whatever you do, there will always be missed opportunities because of imperfect timing. Sometimes prices sharply in your favor within seconds after taking profits. You might second-guess your system and instantly want to re-enter. 

When crypto investing, you can hold to the bottom and eventually profit because most big currencies have long-term potential. In margin trading, that’s the sunk cost fallacy. Nobody enters a trade expecting to be wrong, and leverage can undo losses quickly, so it’s hard to recognize and react to failure before it’s too late.

When Is Leverage Trading Recommended?

Margin and/or leverage trading can be recommended as long as: there’s enough room for error (2x vs 10x), small position size, and confidence in your market analysis. “Recommended” means that you can still lose money, but by taking calculated risks, profit more than lose.

One safer example of leverage is Tether (assuming it doesn’t collapse). Historically it’s rarely deviated over 3 cents, so if you can catch USDT either at 0.97 or 1.03, you can leverage up to 20X with little to “no risk.” Unlike cryptocurrencies, there’s no unlimited upside.

Despite its many opportunities, leverage can’t be recommended in general because its risks have brought more losses than profits. Margin trading, however, doesn’t require leverage and offers traders more options than the overused hold-and-hope.