The crypto industry is in a bull market, and frequent evidence comes from anonymous traders who post their five, six and seven-digit investment returns as screenshots on Crypto Twitter.
This condition creates a situation similar to FOMO, in which everyone gets greedy. The temptation to increase potential earnings by twenty times or more is often overwhelming for most novice traders.
Today, almost all cryptocurrency exchanges offer leveraged trading using derivatives. To enter these markets, the trader must first deposit the guarantee (margin), which is usually a stablecoin or Bitcoin (BTC). However, unlike spot (regular) trading, the trader cannot withdraw from a position in the futures market until it is closed.
These instruments have benefits and can improve the trader’s results. However, those who often rely on incorrect information when trading futures contracts end up with heavy losses instead of profits.
The basics of derivatives
These leveraged futures contracts are synthetic and it is even possible to short sell or place a bet on the negative side. Leverage is the most attractive aspect of futures contracts, but it is important to note that these instruments have long been used in the stock, commodities, indices and foreign exchange (FX) markets.
In traditional finance, traders measure the daily price change by calculating the average changes in the closing price. This measure is widely used in all asset classes and is called volatility. However, for several reasons, this metric is not useful for cryptocurrencies and can hurt leverage traders.
To be brief, the greater the volatility, the more frequently the price of an asset fluctuates. Contrary to what was expected, rising from 7% to 10% every day represents an indicator of low volatility. This is because the deviation from the mean is small, while random fluctuations between negative 3% to positive 3% have a much wider variation.
Markets with very low volatility are perfect for leverage
Knowing the general breadth of how an asset fluctuates is extremely important when opening leverage positions. Take the British pound sterling (GBP), for example, and you will notice that its volatility is generally less than 1%, as aggressive daily price changes and surprises are uncommon.
Foreign exchange markets are relatively stable when compared to stocks and commodities. Therefore, some regulated brokers offer up to 200x of leverage, which means that a 0.5% move against the position would cause a forced liquidation.
For a cryptocurrency trader, the daily change in the Swiss franc (CHF) against the US dollar would likely be seen as a stable currency.
However, Bitcoin’s daily volatility of 3.4% hides a more dangerous price fluctuation. While measuring daily closing prices for traditional markets makes sense, cryptocurrencies are traded non-stop. This difference potentially creates much broader movements on the same day, although daily closure often disguises it.
The average change between Bitcoin intraday high and low over the past 180 days is 6.5%. As shown above, these ‘intraday movements’ have exceeded 10% on 25 occasions. Which means that, in reality, BTC price fluctuations are much larger than expected for a 3.2% daily volatility asset.
The 20x leverage seems crazy, considering Bitcoin’s daily moves
To put things in perspective, a 5% move in the wrong direction is enough to settle any 20x leveraged Bitcoin position. This data is clear evidence that traders should really consider risk and volatility when trading leverage cryptocurrencies.
Quick profits are good, but the most important thing is to be able to survive the usual daily price fluctuations to keep unrealized gains.
Although there is no magic number to define the best leverage for each trader, the effect of volatility must be taken into account when calculating settlement risks. Those who intend to keep positions open for more than a few days, aiming at leverage of 15x or less, appear to be ‘reasonable’.
The views and opinions expressed here are exclusively those of author and do not necessarily reflect the views of Cointelegraph. Every investment and trading movement involves risk. You must conduct your own research when making a decision.