Whenever data is available on futures liquidation, many novice investors and analysts instinctively conclude that these are degenerate players using high leverage or other risky instruments. There is no doubt that some derivatives exchanges are known to induce the retail trade to use excessive leverage, but this ignores the entire derivatives market.
Recently, worried investors like Nithin Kamath, founder and CEO of Zerodha, wondered how derivatives exchanges can handle extreme volatility while still offering 100x leverage.
When a platform offers leverage or funds for the client to buy more than the money in the account, the platform takes a credit risk. With Crypto exchanges offering 10 to 100x leverage (futures), days like today, I wonder who is watching the liquidity position of these platforms 1/2
– Nithin Kamath (@ Nithin0dha) May 19, 2021
On June 16, reporter Colin Wu tweeted that Huobi had temporarily reduced the maximum trading leverage to 5x for new users. At the end of the month, the exchange had banned users based in China from trading derivatives on the platform.
After some regulatory pressure and possible community complaints, Binance Futures limited new user leverage trading to 20x on July 19. A week later, FTX followed up on the decision citing “efforts to encourage responsible trading”.
FTX founder Sam Bankman-Fried claimed the average open leverage position was around 2x and only “a tiny fraction of the activity on the platform” would be affected. It is not known whether these decisions were coordinated or even mandated by a regulator.
Cointelegraph has previously shown how the typical volatility of 5% of a cryptocurrency causes regular liquidation of positions with 20x or more leverage. So, here are three strategies often used by professional traders who are often more conservative and assertive.
Margin traders keep most of their coins in hard wallets
Most investors understand the benefit of keeping the highest possible share of coins in a cold wallet, as preventing internet access to tokens greatly decreases the risk of hacking. The downside, of course, is that this position might not reach the exchange in time, especially when networks are congested.
For this reason, futures are the preferred instruments traders use when they want to reduce their position in volatile markets. For example, by depositing a small margin like 5% of their holdings, an investor can derive a 10x effect and significantly reduce their net exposure.
These traders could then sell their positions on the spot exchanges later after the arrival of their trade and simultaneously close the short position. The reverse should be done for those looking to suddenly increase their exposure using futures. The derivatives position would be closed when the money (or stablecoins) arrives at the spot exchange.
Force cascading liquidations
Whales know that in volatile markets liquidity tends to be reduced. As a result, some will intentionally open highly leveraged positions, expecting them to be forcibly terminated due to insufficient margins.
While they are “apparently” losing money on the trade, they actually intended to force cascading sell-offs to put pressure on the market in their preferred direction. Of course, a trader needs a large amount of capital and potentially multiple accounts to perform such a feat.
Leverage traders take advantage of the “funding rate”
Perpetual contracts, also known as reverse swaps, have a built-in rate that is typically billed every eight hours. The financing rates guarantee the absence of imbalances linked to the exchange risk. Even if the open interests of buyers and sellers match at all times, the actual leverage used may vary.
When the (long) buyers are the ones asking for more leverage, the finance rate becomes positive. Therefore, these buyers will be the ones paying the costs.
Market makers and arbitration bureaus will continuously monitor these rates and possibly open a leverage position to collect these fees. Although it seems easy to execute, these traders will need to hedge their positions by buying (or selling) in the spot market.
The use of derivatives requires knowledge, experience and, preferably, a significant war chest to withstand periods of volatility. However, as stated above, it is possible to use leverage without being a reckless trader.
The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of Cointelegraph. Every investment and trade move involves risk. You should do your own research before making a decision.