For retail investors who are new to the game, here is a sharing of principles for leveraged trading.
If you are involved in leveraged trading, this article is important for you.
I often advise: avoid futures and leverage. Even if you have several years of trading experience, you still need to be cautious. But today, we want to explore how leverage affects the dynamics of the entire cryptocurrency market.
A brief introduction to the principle of leverage
First, let's take a brief look at how leverage works. If you trade with 10x leverage and invest $500, your trading power is equivalent to having $5,000. How is this done? An exchange (such as Binance) will lend you $4,500. But there is a condition: if the price of the asset drops by 10% (that is, your $5,000 assets become $4,500), your position will be automatically closed to ensure that you don't owe the exchange money. This process is called "liquidation."
When your long position is liquidated, it will trigger an immediate market sell-off. This means that your remaining $4,500 will be sold quickly to ensure that Binance can recover its funds.
The impact of large-scale leverage
Now, let's look at this phenomenon from a more macro perspective. Imagine that 100,000 traders are long ETH at three different price levels (2.8K, 3K, and 3.2K) with 10x leverage. If the price of ETH drops from 3K to 2.7K, a 10% drop, all traders who are long at this price will be liquidated.
This will cause a large number of sell orders to emerge, which will significantly lower the market price of ETH. Due to this large-scale liquidation, the price of ETH may further decline to 2.5K, which will trigger the liquidation of traders who entered the market at 2.8K, and so on. This is the so-called chain liquidation phenomenon.
Beware of "flash crashes"
When too many traders use leverage to open positions, the market will face a strong and rapid liquidation risk. This situation may trigger a "flash crash", that is, the price of ETH may plummet by 15-20% in just a few minutes. And this risk is not limited to the cryptocurrency market, but also exists in traditional finance, banks, and hedge funds.
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