What is the leverage effect?

In simple terms, the leverage effect shows how borrowing can boost the return on the money you invest. But that works both ways. Just as it can amplify profits, it can also increase losses. This makes it a powerful but high-risk tool tool in leveraged crypto trading.

If you’ve been trading crypto or are just getting started, you’ve probably come across the term leverage. It’s a way to increase your exposure by borrowing capital – but it also comes with significant risk. So, what is the leverage effect, and why is it so important to understand?

Leverage has been used in traditional finance for decades, especially in business or stock investments. But it’s especially relevant (and risky) in crypto. That’s because crypto markets are highly volatile. When you add leverage into the mix, even small price movements can lead to outsized gains or losses in a very short time.

That’s why it’s essential to fully understand how leverage works before using it. You need to know the metrics, the mechanics, and the risks.

In this guide, we’ll break down the leverage effect in simple terms, explain the key numbers, and show how it plays out in real scenarios, so you can make informed and confident trading decisions.

Definition: What is the leverage effect simply explained?

The leverage effect refers to the use of borrowed capital to amplify potential returns on an investment. Instead of relying solely on your own money, you borrow additional funds to increase your buying power, aiming to make your capital go further.

This concept has long been used in corporate finance, where companies take on debt to grow faster and improve return on equity (ROE). In crypto trading, leverage allows you to open larger positions with less of your own capital and the goal is the same: boost potential returns by efficiently using available funds.

At its core, the leverage effect describes how the relationship between borrowed money and equity can magnify gains, but also intensify losses if the market moves against you. Used carefully, leverage can be a strategic tool. But it’s essential to understand the risks before jumping in.

Leverage means using borrowed money to open a larger position than you could with your own funds alone. It’s expressed as a ratio– like 2x, 5x or 10x– and tells you how much bigger your trade becomes thanks to borrowing. For example, with 5x leverage, a €200 investment lets you open a €1,000 position. If the price goes up by 10%, you make a €100 profit. But if the price drops by 10%, you lose €100,  which is half your original investment.

Unlike traditional investing, where leverage might be used to finance business expansion or real estate, crypto leverage plays out in minutes or hours, with trades opened and closed rapidly based on market movements.

The types of leverage effect

When people talk about the leverage effect, they’re usually referring to one of three outcomes: positive, negative or neutral. These outcomes depend on how your total return compares to the cost of borrowing.

• Positive leverage effect: Your return on the total leveraged position is higher than the borrowing costs. Your return on equity increases.

• Negative leverage effect: Your gains do not cover the cost of leverage, or you incur a loss. Your return on equity decreases.

• Neutral leverage effect: Gains and borrowing costs cancel each other out – there’s no impact on your return.

In crypto, different products apply leverage differently. From margin trading and leveraged tokens to perpetuals and futures, each affects how the leverage effect works in practice, but the basic principle stays the same: using borrowed capital to influence the ROE.

• Margin trading lets you borrow funds to open larger positions. You’ll need to monitor your margin level to avoid liquidation if the market moves against you.

• Leveraged tokens offer built-in leverage in a single product. They automatically rebalance daily, so you don’t need to manage margin or risk manually.

• Perpetual contracts and futures allow you to speculate on price movements without owning the asset. You can use leverage, but these products come with funding rates and expiry terms (in the case of futures).

Looking to trade crypto with leverage but not sure where to start? Explore our smart guide to leveraged crypto trading – it covers different ways to use leverage, shares practical strategies and highlights common mistakes to avoid.

Key metrics behind the leverage effect

To understand how leverage influences your results, you need to know a few key terms. Think of these as your toolkit for navigating leveraged trading:

• Return on equity (ROE): Your net profit compared to the capital you invested.

• Return on total capital (ROTC): Your return based on the full amount invested, including borrowed funds.

• Cost of leverage: Includes daily fees, interest, or funding rates applied to the borrowed amount.

• Leverage ratio / Debt ratio: Tells you how much capital is borrowed relative to your own funds.

The formula for calculating the leverage effect

To calculate whether your trade is likely to deliver a positive leverage effect or cost you more than it earns, use this formula:

Return on equity = Return on total capital + (Return on total capital – Cost of debt) × (Debt / Equity)

In crypto, the “cost of debt” is not just one thing but includes several fees you will need to keep in mind:

• Buy fees: Charged when opening a leveraged trade. 

• Funding fees (or interest fees): Charged for holding a margin position open. Timing varies by platform – on Bitpanda, they accrue every 4 hours.

• Liquidation fees: Applied if your position is automatically closed due to insufficient margin.

• Closing fees: Taken when you manually exit a leveraged trade.

Example: the leverage effect in action

Imagine you invest €1,000 in your margin account and use 5x leverage to open a €5,000 position in Bitcoin (BTC). 

• If the price of BTC increases by 10%, your position gains €500 – that’s a 50% return on your original investment.

• But if BTC drops 10%, you’d lose €500, which means that half your capital is gone.

In both cases, the market only moved 10%. That’s the leverage effect in action: it amplifies outcomes. The higher the leverage, the faster your equity can grow or disappear.

Pros and cons of the leverage effect

Whether you're trading crypto or traditional assets, understanding both the advantages and disadvantages of the leverage effect is essential:

Advantages of the leverage effect

• Leverage allows you to open larger positions while committing less of your own capital.

• It helps amplify your gains even when the market moves only slightly.

• You can trade both rising and falling markets by going long or short.

• It also lets you use your available funds more efficiently across different trades.

Disadvantages of the leverage effect

• Leverage increases your exposure to market volatility, making trades more sensitive to price swings.

• If your margin falls below a certain level (the liquidation threshold), your position may be liquidated, resulting in a total loss of your capital.

• Daily fees and closing fees can add up over time, reducing overall profitability.

• Trading with leverage demands constant attention and disciplined risk management to avoid significant losses.

Risks of using leverage in crypto trading

Leverage can boost your profits, but it also makes every trade riskier. That’s why it’s essential to understand what you’re getting into before opening a leveraged position.

When the market moves in your favour, the leverage effect works for you. But when prices drop, losses stack up just as fast, and can quickly eat into your equity. In crypto markets, where volatility is high and price swings are common, even small movements can lead to outsized losses.

One of the biggest risks is liquidation. If your position loses too much value and your margin level drops below a certain threshold, your trade will be closed automatically. This means you lose the capital you invested, and may also be charged a liquidation fee.

You also need to factor in daily trading fees, interest on borrowed funds, and closing fees. These extra costs reduce your profits or deepen your losses, especially if you hold a position for more than a few hours.

Read more about the risks and strategies to mitigate them in our smart guide to leveraged crypto trading. 

Trade with leverage on Bitpanda 

With Bitpanda, you can trade with borrowed capital across a growing range of leveraged products – directly on the Bitpanda platform. Whether you want full control over your trades or prefer a simpler approach, you’ll find tools designed to match your strategy.

Bitpanda Margin Trading* lets you trade more than 100 cryptocurrencies with up to 10x leverage. Go long, track your positions in real time and manage risk with ease. Liquidation alerts help you stay informed, and with Margin Limit Orders – including Take Profit and Stop Loss – on the way, you’ll soon have even more control to fine-tune your strategy.

If you prefer leveraged exposure without actively managing margin, Bitpanda Leverage also offers leveraged tokens. These track the daily performance of an asset at a fixed leverage level – like 2x long or short – and are ideal for short-term market moves. There’s no need to manage collateral or worry about liquidation, making them a straightforward way to access leverage.

Start exploring your leverage options with Bitpanda today and find the product that fits your strategy.

Frequently asked questions about the leverage effect

Here are answers to the most common questions about leverage.

When is the leverage effect used?

The leverage effect is used when companies or investors want to boost return on equity using debt. It’s common in corporate finance, real estate and leveraged crypto trading. Leverage can help finance growth or increase investment capacity, but it also carries increased risks.

When does the leverage effect take effect?

The leverage effect kicks in when the return on total capital is higher than the cost of debt. In this case, return on equity increases and the effect is positive. If the return is lower than the cost of debt, the effect turns negative and reduces profitability.

How can you calculate the leverage effect?

You can calculate the leverage effect using this simple formula:

Return on equity = Return on total capital + (Return on total capital – Cost of debt) × Debt ratio

The difference between return on total capital and the cost of debt shows whether the effect is positive or negative. A high debt ratio amplifies leverage in both directions.

More topics around trading

Want to learn more about how to use leveraged trading effectively and manage risks better? In the Bitpanda Academy, you'll find a wide range of guides and tutorials that explain not only the basics of investing and trading but also delve into topics like cryptocurrencies, stock trading, blockchain technology, and various trading strategies.

• What is Spot Trading?

• Limit Orders

• What is Volume Trading?

Disclaimer

Bitpanda Leverage is brought to you by Bitpanda Financial Services (AT company registration no. FN551181k). L-Token-Long allows you to invest in increasing market prices of selected crypto assets by entering into a contract for differences (CFDs) with Bitpanda GmbH (AT company registration no. FN 569240 v). L-Token-Short allows you to invest in expected falling market prices of crypto assets by entering into CFDs. CFDs are financial instruments of which the value is derived from the price of crypto assets as the underlying. This price is quoted in EUR on Bitpanda. If your selected default currency or the currency of your trade is different to EUR, your final return will also depend on the exchange rate between EUR and your chosen currency. Section 5 of the Investor Information Document (available at bitpanda.com) provides you with more information on the risks associated with Bitpanda Leverage. Relatively small market movement has a proportionally larger impact on your position: this can work both for you and against you. Before you decide to invest, you should carefully consider your investment objectives, experience, financial resources and willingness to take risks.

*Margin trading involves borrowing crypto assets to amplify potential gains and losses. Even small market fluctuations can lead to margin calls or automatic liquidation, potentially resulting in the loss of your entire capital. Borrowing fees accrue every 4 hours and adversely affect your margin level. Margin trading is suitable for experienced traders only. Ensure you understand the risks and can bear substantial or total financial loss. Never trade with money you cannot afford to lose.