The crypto sector is in a bull market and common evidence comes from anonymous traders posting their five, six and seven digit investment returns as screenshots on Crypto Twitter.
This state creates a FOMO-like situation where everyone becomes greedy. The temptation to increase potential profits twenty times or more is often irresistible to most beginners.
Nowadays, almost every cryptocurrency exchange offers leveraged derivatives trading. In order to enter these markets, a trader must first deposit collateral (margin), which is usually a stablecoin or bitcoin (BTC). In contrast to (regular) spot trading, however, the trader can only withdraw from a futures market position once it has been closed.
These tools have advantages and can improve a trader’s results. However, those who frequently rely on incorrect information when trading futures contracts are more likely to experience large losses than gains.
The basics of derivatives
These leveraged futures contracts are synthetic and it is even possible to shorten a bet or place it down. Leverage is the most attractive aspect of futures contracts, but it’s worth noting that these instruments have long been used in stock markets, commodities, indices, and foreign exchange (FX).
In traditional finance, traders measure the daily price change by calculating the average closing price change. This metric is widely used in every asset class and is known as volatility. However, for various reasons, this metric is not helpful for cryptocurrencies and can harm leverage traders.
In short, the higher the volatility, the more often an asset price swings wildly. Contrary to expectations, a daily increase of 7% to 10% is an indicator of low volatility. This happens because the deviation from the mean is small, while random fluctuations between negative 3% and positive 3% represent a much larger range.
Very low volatility markets are perfect for leverage
When opening leverage positions, it is extremely important to know the general range of oscillations of an asset. Take the British Pound Sterling (GBP) as an example, and you will find that its volatility is typically below 1% as surprisingly aggressive daily price changes are unusual.
Foreign exchange markets are relatively stable markets compared to stocks and commodities. As a result, some regulated brokers even offer 200x leverage, which means that a 0.5% movement on 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 a stable coin.
However, the 3.4% daily bitcoin volatility hides a more dangerous price fluctuation. While measuring daily closing prices makes sense for traditional markets, cryptocurrencies trade without interruption. This difference potentially results in much larger movements in the same day, although daily closing often masks it.
The average change between the Bitcoin intraday high and low over the past 180 days is 6.5%. As shown above, these “intraday moves” exceeded 10% 25 times. In reality, for a daily volatility value of 3.2%, BTC price fluctuations are much larger than expected.
The 20x leverage seems insane given Bitcoin’s daily movements
To put things in perspective, moving 5% in the wrong direction is enough to liquidate a 20-fold leveraged Bitcoin position. This data is clear evidence that when leveraging cryptocurrencies, traders should really consider risk and volatility.
Quick wins are nice, but what is more important is the ability to weather the usual daily fluctuations in price to cling to those unrealized gains.
While there is no magic number to determine the best leverage for any trader, the effect of volatility must be taken into account when calculating liquidation risk. Those looking to hold positions open for more than a few days and aiming for leverage of 15x or less seem “reasonable”.
The views and opinions expressed here are solely those of author and do not necessarily reflect the views of Cointelegraph. Every investment and trading step is associated with risks. You should do your own research when making a decision.