Leverage

As it relates to both CeFi and DeFi, leverage is simply borrowed capital. In leverage trading strategies, a coin investor may start with an equity or principal position and borrow more capital. This allows the trader to expose a greater amount of capital, up and above their principal position, to a trading strategy. 

Leverage is often referred to as a multiple, such as 5X, 10X or 100X. A common leverage limit on centralized exchanges (CEX’s), 10X, implies that with $1000 worth of a stablecoin, such as Dai or USDC, a borrower can get a loan totaling $10,000 to put to work in a leverage trading strategy. In this example, the trader can now purchase $10,000 worth of BTC, having started with only $1,000 of principal capital. In exchange for the luxury of using borrowed capital, the leverage trader must pay an ongoing interest rate to use that capital.   

In Defi, lending protocols like Compound and Aave have been pioneers in driving liquidity to lending markets. Through innovative governance tokens and Interest paying schemes, these platforms have provided an avenue for DeFi traders to take leveraged trading positions at DEX’s. 

Leverage has a significant effect on trading strategies. Leverage magnifies the returns, both gains and losses, of a trading strategy. For example, a 100% return on a non-levered principal position of $1000 would leave an investor with $2000 once the position has been closed. With leverage of 10X on a $1000 starting position in the same strategy, the trader would be left with $11,000 once the position is closed and the loan paid back: $1,000 of equity capital + $10,000 of borrowed capital. Total exposure of $11,000 at 100% return = $22,000. $22,000 – $10,000 loan = $12,000.  – a return of 1200% on starting equity capital. 

Because of its magnifying effect, leverage trading can introduce significant risk to principal capital. In order to lose all principal capital in a single un-levered coin trading position, the price of the coin would need to go to 0. With leverage, smaller price moves of the borrowed position can put the entire principal amount at risk. With leverage of just 2x, a price drop of 50% on the leverage trading position puts the collateral at risk of being seized and the position closed out to repay the loan.

But despite the risks involved, leverage allows coin holders to “put their coins to work” and also allows for traders to execute strategies with larger amounts of capital than their principal amount might otherwise afford.