What is Financial Leverage? How to use it wisely in Crypto?

1. What is Financial Leverage?

Financial leverage is a powerful tool that helps investors utilize capital to seize investment opportunities, aiming to increase profit margins by expecting future asset values to exceed borrowing costs, thus yielding higher benefits.

Using financial leverage allows you to gain potential profits from the entire transaction with only a small portion of your own money. The borrowed funds can come from banks or financial institutions.

To visualize what financial leverage is, consider the following example:

Mr. A buys an apartment B under construction with a total payment of 2 billion VND. However, he only has 500 million VND in capital, so Mr. A borrows 1.5 billion VND from the bank. After 1 year of completion, Mr. A sells it for 2.5 billion VND. Subsequently, Mr. A finds a buyer who agrees to purchase it.

Deducting the borrowed amount of 1.65 billion VND (150 million VND in annual interest) and the initial capital of 500 million VND, Mr. A earns 350 million VND in profit after one year of investment.

Using financial leverage effectively can bring substantial benefits. However, it also carries many risks if not used carefully. In the worst-case scenario of the above example, if Mr. A cannot sell the house, he would bear the borrowed amount of 1.5 billion VND along with the monthly interest payments.

2. The role of financial leverage?

Although it carries many risks, financial leverage remains a favored financial tool for businesses and investors.

Financial leverage allows investors or businesses to use borrowed money to generate higher returns from a specific investment or business activity.

Through financial leverage, one can invest or acquire assets with a small portion of their own capital and use borrowed funds to supplement the amount.

When the asset increases in value or the business achieves profits, the benefit for the investor is calculated based on the total asset value or profit, rather than just the amount they invested.

Thus, financial leverage has the following roles:

Optimizing Capital: Financial leverage allows businesses to compensate for capital shortages to maintain operations. For individual investors, it enables them to use a smaller amount of their own capital to achieve higher profits.
Increasing Profit: Financial leverage is an effective tool for boosting profits. When used wisely and combined with thorough analysis, it can yield higher returns. However, it is important to note that the use of leverage also comes with risks, so it must be managed carefully.
Tax Benefits: Loans and interest payments are considered business expenses. When calculating taxes, these amounts can be deducted from taxable income. This helps businesses reduce their tax liability and increase net profits.

3. When to Use Financial Leverage?

Before considering using financial leverage, you need to firmly grasp the personal finance management formula as follows: Reduce expenses, increase income, invest, leverage.

You should follow this order to avoid falling into financial traps. Most so-called experts in the market advise you to do the opposite of this order, and you may even end up paying a lot of money for their courses, only to end up in debt due to following their financial advice.

In 2021 and 2022, the real estate market in Vietnam saw a significant boom, with "for sale" signs appearing everywhere from urban areas to rural regions. Numerous wealth-building and real estate investment courses sprang up, with these so-called experts always teaching the masses that "You must know how to leverage bank loans." Yet, as you saw in 2023, with rising bank interest rates and a frozen real estate market, many people ended up having their assets seized and going bankrupt.

Once you have mastered your cash flow, controlling the inflow and outflow of money, and have a firm grasp of investment skills, then you can use financial leverage to increase your assets smartly, without being pressured by interest rates.

4. Using Financial Leverage in Crypto

4.1. What is Margin?

In the Crypto market, Margin or margin trading is a form of using financial leverage.

Margin comes with several related terms, including:

Margin (Collateral): The amount of money you use to purchase an investment.
Leverage: Using leverage means increasing your investment amount. For example, investing $1,000 with a x100 leverage means you are actually investing $100,000.
Volume: The product of (Margin) x (Leverage).
Position: Refers to the trading stance, including Long (buying) and Short (selling).
Liquidation: This is the liquidation price. For example, if you are margin trading Bitcoin and the BTC price exceeds the liquidation price, your entire investment will be lost.

Example: You have $10,000. The current price of ETH is $1,000, and you predict that ETH will rise to $1,100.

If you engage in Spot Trading, when the price increases to $1,100, you would make a profit of $1,000. However, to optimize your profit, you decide to open a Long position with a 10x leverage.

=> This means you have placed a buy order for ETH at $1,000 with a total volume of $100,000. Essentially, you have borrowed $90,000 from the exchange. At this point, you hold 100 ETH. If ETH rises to $1,100 and you close the position to take profit, you would earn a profit of $10,000 compared to $1,000 if trading normally, after repaying the loan to the exchange (not including interest).

In the opposite case, if the price of ETH drops to $900 and hits the liquidation price, the exchange will sell all 100 ETH at $900. You would then need to repay the entire $90,000 loan to the exchange. Your account would be left with nothing, resulting in a liquidation of your account.

4.2. Advantages and Disadvantages of Margin

Advantages

Optimizing Capital: Traders with limited capital can use leverage to increase their profits. If the position is closed successfully, traders have the opportunity to earn much higher returns than usual. For example, a trader with $1,000 in capital can open a position of $100,000 with 50x leverage. If the market moves positively by just 3%, that account would earn $1,500. Without leverage, the same $1,000 trading account would only see a profit of $15.
Earning Profits Even in a Downtrend: A notable feature of the crypto market is that you can still earn profits during a downtrend by using short positions in Margin trading. For example, if BTC was priced at $69,000 and you believed this was the peak for BTC in this cycle, you could open a short position at $69,000. With the current BTC price at $26,000, you would have successfully earned profits in a downtrend.

Disadvantages

Risks from Price Volatility: The crypto market has very high volatility and is highly sensitive to news, making your position vulnerable to liquidation during significant market fluctuations.
Risks from Investors Themselves: If an investor misjudges the market trend and uses high leverage, their account is at high risk of liquidation.

4.3. Notes when using everage in the Crypto Market

Using Margin can open up opportunities for quick profits. When applied wisely, you can even earn up to 100 times more compared to traditional trading, regardless of whether the market is trending up or down. However, high profits come with high risks. Therefore, you should only use Margin when you meet the following requirements:

Experience: You need to be an experienced trader, well-versed in technical analysis principles, capable of reading charts, and have a clear understanding of market mechanisms and trends. For new traders, especially those who are not familiar with how Margin works and the cryptocurrency market, using Margin can be highly risky and it’s best not to chase after high profits.
Stable Market: Margin is usually best utilized when the market shows clear and stable signs of upward or downward movement. Avoid using Margin during sideways markets or when signals are unclear.
Short-Term Trading: Margin is generally more effective for short-term trades. Using Margin for long-term trades may not yield good performance and could involve higher risks of loss.

5. Conclusion

High profits always come with high risks. Remember that using financial leverage requires a deep understanding of the market and strong trading skills. If you are not confident or lack sufficient experience, it is advisable to avoid using leverage to avoid unnecessary risks.

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