What is the leverage effect?

The leverage effect shows how you can use borrowed capital to open larger positions and increase the return on your invested capital. However, be careful: leverage can also amplify losses, especially in volatile markets such as cryptocurrencies. In this guide, you’ll learn what leverage means, how to calculate the leverage effect and which risks you should consider when trading.

• Meaning: The leverage effect simply describes how the use of borrowed capital can influence return on equity and lead to stronger fluctuations in returns.

• Requirements: A positive leverage effect only arises when the return on total capital (return on all capital employed) is higher than the cost of borrowed capital and the level of debt (ratio of borrowed capital to equity) isn’t too high.

• Calculating the leverage effect: Using the formula return on equity = return on total capital + (return on total capital – cost of borrowed capital) × (borrowed capital / equity), you can calculate whether using borrowed capital is worthwhile for you.

• Risks: Leverage can significantly accelerate losses and, through costs such as interest and fees, substantially reduce your return on equity.

Definition: What is the leverage effect?

The leverage effect describes how the use of borrowed capital can affect return on equity, both in trading and in corporate finance.

Specifically, the leverage effect shows that return on equity changes more strongly than return on total capital when you use borrowed capital in addition to your own equity. In trading, this applies to leveraged positions, while in corporate finance it applies, for example, to investments financed through loans. If an investment performs well, return on equity can increase disproportionately; conversely, it can also fall more sharply.

Depending on the relationship between return and costs, three types of leverage effect can be distinguished:

• Positive leverage effect: your return on total capital is higher than the cost of borrowed capital (e.g. interest or fees for borrowed funds), which increases your return on equity.

• Negative leverage effect: your return on total capital is lower than the cost of borrowed capital, which reduces your return on equity.

• Neutral leverage effect: return and costs balance each other out, resulting in no additional effect.

Leverage effect: What does “leverage” mean in trading?

In trading, leverage describes how you can use your equity and additional borrowed capital to control a larger position, which can also lead to greater fluctuations in gains and losses. In this context, leverage means using borrowed capital to increase your market position. This allows you to take a significantly larger position with comparatively low equity. Leverage is expressed as a ratio, e.g. 2x or 5x, and determines how much your position is increased relative to your equity.

In crypto trading, the effect of leverage becomes particularly apparent, as prices can often change significantly within minutes or hours. In combination with leverage, high volatility can cause price movements to have a rapid and substantial impact on your return on equity. Depending on the format, leverage is implemented differently in trading, but the basic principle remains the same: you use borrowed capital to increase your return potential. At the same time, your risk also increases.

Typical forms and uses of leverage at a glance:

• Leveraged tokens bundle a fixed level of leverage into a single product and are automatically rebalanced daily, so you don’t need to manage margin and risk manually.

• Perpetual contracts and futures allow you to speculate on price movements without owning the underlying asset, while using leverage, but you should consider funding fees and, for futures, expiry dates.

• Margin trading allows you to borrow capital to open larger positions – however, you should always monitor your margin level to avoid liquidation if the market moves against you.

Do you want to use margin trading and take advantage of opportunities in a targeted way? Then trade on the Bitpanda platform with leverage. However, always keep the associated risks in mind.

With this formula, you can calculate the leverage effect

You can use this formula to calculate whether a trade delivers a positive leverage effect or costs you more than it generates:

Return on equity = return on total capital + (return on total capital – cost of borrowed capital) × (borrowed capital / equity)

Legend:

• Return on equity (ROE) or return on equity: your net profit in relation to your invested capital

• Return on total capital (ROTC) or return on total capital: the return based on the entire position, including borrowed capital

• Cost of leverage: includes daily fees, interest or funding rates on the borrowed capital

Which costs you need to consider when using leverage

In the crypto sector, the “cost of borrowed capital” usually consists of several fees that you should consider in your trading:

• Purchase fees: apply when you open a leveraged position

• Financing costs (or interest fees): arise when you keep a position open, though the intervals vary depending on the platform – on Bitpanda, they are charged every four hours

• Liquidation fees: apply when your position is automatically closed because your margin is insufficient

• Closing fees: apply when you manually close a leveraged position

These costs can reduce your return on total capital and therefore determine whether the leverage effect improves or worsens your return on equity.

Examples: how leverage amplifies gains and losses

An example is the simplest way to show how the leverage effect can influence your results:

You invest 1,000 euros of equity and use 5x leverage to open a position worth 5,000 euros.

• If the price rises by 10%, you achieve an unrealised gain of 500 euros – this corresponds to a return of 50% on your invested capital before fees.

• If the price falls by 10%, you incur an unrealised loss of 500 euros – that is 50% of your equity, also before costs are considered.

The price movement remains the same, but the impact on your equity is significantly greater. Please note: these gains or losses are only realised when you close your position or it is liquidated.

Requirements – when does the leverage effect work positively?

The leverage effect works positively when the return on total capital is higher than the cost of the borrowed capital used. This means your investment must generate more than the borrowed capital costs you. Only then does your return on equity increase through the use of leverage.

For a positive leverage effect to occur, the following requirements should be met:

• The return on total capital is higher than the cost of borrowed capital: your position generates a higher return than you pay in interest and fees

• Costs remain manageable: high financing costs can quickly offset the advantage of leverage

• The market moves in the expected direction: price movements have a stronger impact on your equity due to leverage

As soon as the cost of borrowed capital exceeds your return, the effect reverses and becomes negative.

Risks of leverage trading

Whether you trade cryptocurrencies or other assets, you should always consider the risks of leverage.

Here are the disadvantages at a glance:

• Because leverage amplifies price movements on your equity, your positions react more sensitively to price fluctuations

• If the margin level falls below the required threshold, your position may be liquidated

• Ongoing fees can reduce your returns

• You should always monitor your positions and manage risk in a disciplined way (for example, by setting clear loss limits)

Leverage on Bitpanda

With Bitpanda, you can trade leveraged products directly on the platform – using borrowed capital and tailored to your strategy. Bitpanda Margin Trading* gives you access to more than 100 cryptocurrencies – with up to 10x leverage. You can take long positions, track your positions in real time and actively manage your risk. Liquidation alerts keep you informed. In addition, margin limit orders – including stop loss and take profit – give you even more control over your strategy.

If you want to use leverage without managing margin and risk yourself, Bitpanda Leverage offers leveraged tokens. These track the daily performance of an asset with a fixed leverage – such as 2x long or short – and are ideal for short-term market movements. You don’t need to provide collateral and don’t have to worry about liquidations. This gives you direct and straightforward access to leveraged trading.

Explore your leverage options with Bitpanda now and find the product that suits your strategy.

Conclusion: understanding and using the leverage effect consciously

The leverage effect shows how the use of borrowed capital influences return on equity – both in trading and in companies that increase their total capital through loans, for example to finance growth.

At its core, everything depends on the relationship between total capital, debt and the costs incurred. If the return is higher than the borrowing rate or the interest rate on the borrowed capital, the use of leverage can have a positive effect on your return on equity. If this isn’t the case, the effect turns negative.

A key factor here is the level of debt: the higher the proportion of borrowed capital relative to equity, the stronger the impact of price movements or investment outcomes on your returns. This applies equally to corporate finance and crypto trading.

Using leverage usually requires more experience and a solid understanding of risks and market mechanisms. For advanced crypto traders, Bitpanda Fusion offers additional opportunities to implement more complex trading strategies.

Further topics on trading

Do you want to use margin trading more effectively and deepen your knowledge? In the Bitpanda Academy, you’ll find practical guides – from the secure use of a wallet for leveraged positions to the impact of inflation on your trading strategy and how to diversify your portfolio to better manage risks when using leverage.

• What is spot trading?

• What are limit orders?

• What is volume trading?