If you struggle in understanding leverage an margin calculations, this article enlightens you with a few simple examples. I will show you how I learned the topic.
Leverage and Margin
Why do leveraged trading
Leveraged trading comes into play if you want to buy (long) or sell (short) an asset for
- which you do not have enough funds or
- do not want to risk all funds with a single trade or
- do not trust the broker and want to have less money stored there.
Example for Leverage and Margin
For example if you buy a stock for 1000$ and the stock goes up 10% you eventually win 100$ (10% of your investment). However, the 1000$ are locked up in the trade.
With a 10x leveraged trade, 100$ invested will lead into a 1000$ trade (factor of 10). You move 1000$ of capital by providing a margin (call it safety for the exchange) of 100$.
If the stock goes up 10% you earn the same amount (100$), but this time this is equal to 100% of the invested 100$ (10% x Leverage 10 = 100%).
However, if the stock goes down 10% to 900$ all money (called margin) of 100$ is consumed and the trade will close immediately (margin call). The 900$ limit is called the liquidation price, as the trade is liquidated (closed) at this price level.
Risk and reward obviously go in both directions.
About the Deribit Exchange
Deribit is a trading platform for crypto currencies. At the moment they offer Bitcoin and Ethereum for long and short trades. For both coins, there are perpetual (ongoing) and terminated futures tradeable. Additional they offer buying / selling various call or put options for future price points.
If you’re interested on how to multiply your bitcoin, leveraged trading is a way in doing so.
I do not recommend that you jump into leveraged trading. This is no investment advice. Do your own research and only invest in products and services you understand 100%. All numbers are to show you the mechanics of leverage and margin.
Calculating Leverage and Margin
I’m going to use mainly Ethereum (price levels) for the example, but it’s basically the same for Bitcoin or other leveraged trading instruments like forex.
How to calculate margin needed for a trade
This one is simple. At Deribit, the Ethereum future has a leverage of 50x. So, If you trade 1 ETH, your margin needed for that is (1 ETH / 50) = 0.02 ETH.
This means, that you have to provide at least 0.02 ETH in your account balance to start a trade of size 1.0 ETH.
Here you can see the leverage effect: In case ETH is moving, lets say from 1000$ to 1010$ (increases 1%), your trade will increase with 1% x 50 = 50%, so you have 0.02 x 1.5 = 0.03 ETH in your balance.
If it moves down to 990$ (minus 1%) you will lose 50% of your trading investment, setting your balance back to 0.02 x 0.5 = 0.01 ETH.
How to calculate Liquidation Price of a Trade
You can also see, that if the trade “consumes” the 0.02 ETH (0.02 x 1000$ = 20$), meaning that ETH price moves down to 1000$ – 20$ = 980$ your trade will be liquidated.
Now say, you have 1 ETH in your balance but trade only 1 ETH. Again, this means because of the 50x leverage, only 0.02 ETH of your balance is reserved to margin. You still have 0.98 ETH left (which could be used for other trades or serve as a sort of insurance for your running trade).
For calculating the liquidation price of a trade you simply solve the following equation:
liquidation_price = size_of_position [$] / (position_size [ETH] + margin_left [ETH])For the above example, this means: 1000$ / (1 ETH + 0.98) = 505$
Important: you will then lose all funds in the account, so basically, even with 10 ETH in your balance a trade will be liquidated at around 91$.
