Managing Overleverage and Margin Calls of Your Crypto Trades

In a world where risk meets reward with every click of the mouse, the allure of leverage is undeniable.  However, along with the promise of profit comes the risk of overleverage and margin calls, two pitfalls that can quickly turn a winning trade into a devastating loss. 

Read below and find out what overleverage and margin calls are, why they pose a threat to crypto traders, and most importantly, the strategies to manage and mitigate these risks effectively.

What Is Leverage and Overleverage in Crypto Trading

Picture this scenario: you believe that the price of Bitcoin will increase over the next few days due to some upcoming positive news in the market. You have $10,000 to invest in Bitcoin. Without leverage, you could simply buy $10,000 worth of Bitcoin.

However, you want to maximize your potential profit from this price increase. So, instead of buying $10,000 worth of Bitcoin, you decide to use leverage, which means borrowing money from the crypto exchange. Most cryptocurrency exchanges allow traders to use leverage for their trades. You can also choose a broker or credit facilities extended by some trading platforms, such as LiteFinance.

Let's say you use 2x leverage, meaning you borrow an additional $10,000 to invest alongside your own $10,000, resulting in a total investment of $20,000.

If the price of Bitcoin increases as you predict, let's say by 10%, your $20,000 investment would now be worth $22,000 (a $2,000 profit). After repaying the borrowed $10,000 plus interest and fees, you're left with $21,000, resulting in a profit of $11,000 ($21,000 - $10,000 initial investment).

In this scenario, using leverage has effectively doubled your profit compared to if you had only used your own funds without leverage. 

So, leverage works as a position size multiplier.  You can use it when you want to boost your buying power, and for that, you borrow capital to increase the potential ROI.

However, if the market moves against you, you could lose a significant amount, even more than your initial investment.

Overleverage occurs when you use a higher ratio for your trades compared with the potential profit that you’ll make. For example, you choose a leverage ratio of 10X (open a position 10X the value of your initial deposit), but ultimately, your position gives a 5X return on investment. 

This means you’ve multiplied your losses instead of multiplying your profits – one of the main risks of overleveraging. 

What is Margin and A Margin Call

Margin represents the initial capital you deposit in your trading account. This is a requisite amount the crypto exchange requires to give you access to margin trading (the known method of borrowing assets to trade cryptocurrencies).  In essence, you need margin if you want to open a leveraged trade.

This margin, also known as collateral, works like a downpayment for a loan, meaning you need an amount of money to put up as a guarantee against losses. This means that with any lost trade, your margin will be lost too. So, when you close your position, you’ll have to repay the borrowed sum along with any accrued interest.

If your account falls below the required margin level, that’s when a margin call occurs. That means the exchange will demand additional funds to cover potential losses on a leveraged position. Failure to meet a margin call typically results in the forced liquidation of your position, potentially leading to substantial losses.

The main risks associated with margin calls include:

Liquidation of assets –  If you can’t meet the margin call by depositing more funds, the broker has the right to sell your securities to increase the account balance to the required level. This could result in the sale of securities at an unfavorable time or price.

Additional investment required – A margin call requires you to either deposit more money into your account or close out positions to bring your account back to the required level. If you don’t have additional funds to deposit, you may be forced to close your positions at a loss.

What’s the difference between leverage and margin?

Leverage refers to the increased trading capacity from borrowed funds, while margin is the amount of your own money used to secure this borrowing. However, all the profits you make from leverage trading belong entirely to you.

Useful Tips to Manage Overleverage and Margin Calls

While the risks of overleverage and margin calls are real, they can be effectively managed with the right strategies. Here are some key approaches for crypto traders to consider:

Risk Management

Set strict risk limits

Determine the maximum percentage of your trading capital that you're willing to risk on any single trade. This helps prevent overexposure and limits potential losses.

Use stop-loss orders

Implement stop-loss orders to automatically exit a trade at a predefined price level. This helps mitigate losses and prevents emotions from driving trading decisions.

Position Sizing

Calculate appropriate position sizes

Base your position sizes on your risk tolerance, account size, and the volatility of the assets you're trading. Avoid overleveraging by only using a fraction of your available capital for each trade.

If you're new to margin trading, begin with a small amount of leverage and gradually increase as you gain more experience and confidence in managing your trades.

Additionally, you can use Altrady’s risk reward calculator and get instant data on the risk level based on your positions. This allows you to adjust your trades based on the size of your portfolio, the size of your exchange account, or based on a specific amount.

Consider the impact of leverage

Be mindful of the leverage ratio you're using and its potential impact on your account. While leverage can amplify profits, it also amplifies losses, so use it judiciously.

Diversification

Spread risk across multiple assets

Diversification is key to reducing the impact of adverse price movements on your overall portfolio. Avoid putting all your capital into one asset or trading strategy.

Consider non-correlated assets

Invest in assets that have low correlations with each other to further spread risk and minimize the likelihood of simultaneous losses.

Maintain adequate collateral 

Always ensure you have enough collateral in your account to avoid margin calls. Monitor your positions regularly and be prepared to add more collateral if the market moves against you.

Continuous Monitoring

Stay informed

Keep abreast of market developments, news, and trends that may affect the assets you're trading. Being aware of potential catalysts for price movements allows you to adjust your trading strategy accordingly.

Monitor account balance and margin levels

Regularly check your account balance and margin requirements to ensure you have sufficient funds to cover potential losses. Be proactive in addressing margin calls to avoid forced liquidation.

The Bottom Line

The key takeaway: while margin and leverage can offer higher returns, they also come with increased risks, and it's essential to approach them with caution and knowledge. 

You can effectively manage and mitigate these risks with a disciplined approach to risk management, prudent position sizing, diversification, continuous monitoring, and ongoing education.