Leverage – The Double-Edged Sword Of Crypto Trading
The spectacular rise in cryptocurrency value in the last year has captured the attention of the mainstream media and many potential novice investors. With the one year return for Bitcoin over 700% and Ethereum over 4,000% the “fear of missing out” is strong. Leverage as a trading option is now a reality, providing both risks and opportunities for crypto enthusiasts.
This has led some people to use borrowed capital to purchase cryptocurrency, anticipating that prices will continue to rise and gains could be used to pay back the loans and interest expense. However, in a notoriously volatile cryptocurrency market, this a dangerous prospect.
Leverage is a fairly simple concept – instead of putting up the full market value of an asset such as Bitcoin, the trader operates on ‘margin’ – 25:1 leverage (or 25x) means that for every dollar the trader stakes in equity, they can trade $25. This is also known as a 4% margin trade.
Let’s assume a would be crypto-millionaire, with the world’s worst market timing, decided to use their credit card to purchase Bitcoin in late December 2017. They locked in a purchase price of $18,000 with a average credit card interest rate of 15% yearly. In the coming months the Bitcoin price dropped to a low of around $7,000.
It is clear that this hypothetical investor is in a precarious position. They are forced to either pay compounding high interest rates or liquidate part of their position at a sizable loss.
Warren Buffet, considered by many to be the greatest investor of the modern era, issued a warning about using leverage in his recent Berkshire Hathaway annual letter, “Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions” (pg. 10). Buffet also shared a humorous quote with CNBC:
[su_quote cite=”Warren Buffett”]My partner Charlie says there is only three ways a smart person can go broke: liquor, ladies and leverage.[/su_quote]
Sensing the danger of underwater borrowers, credit card companies have moved to prohibit the purchase of cryptocurrency. According to Fortune, JP Morgan, Bank of America, Citigroup, Capital One, and Discover have all announced plans to ban cryptocurrency purchases using their cards.
Taking on debt to fund cryptocurrency purchases is one way to leverage the trade; however, financial products such as options and futures contracts are another way to add leverage.
Bitcoin futures have hit the mainstream for US investors with the Chicago Board Options Exchange and the Chicago Mercantile Exchange. Through the use of options and futures, investors can capitalize on price movements if they can get the timing right. Much larger investment gains can be achieved by being correct on a futures or option contract compared to simply holding the underlying asset.
For those feeling particularly confident BitMEX offers a 100x leverage bitcoin futures contract! The risks associated with this amount of leverage are astronomical if used incorrectly. Even small movements in the price of the underlying asset can cause massive losses.
Now let’s go back to our trader who bought at $18k on a credit card using 100x leverage, while the price swung back to $6k… it’s easy to see how this poor schmuck is rapidly kissing goodbye to his money, his car, his house, and possibly his nu… sanity, when his family finds out.
While highlighting the dangers of leverage it is important to not make sweeping generalizations. Leverage is not inherently a bad thing, and it can be used intelligently and responsibly. One example would be using options or futures contracts to hedge a position.
However, when using complex financial products it is essential to understand the risks involved. Buying Bitcoin on a credit card and then using that Bitcoin as margin for a 100x leveraged future will not lead to restful nights of sleep. As the old adage goes… don’t invest more than you can afford to lose.
And with leverage like that, it could be everything.
Financial Disclosure: The author holds long positions in Bitcoin and Bitcoin Cash. The author holds no short positions.