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Leverage is a concept in finance that relies on using borrowed funds to increase returns (and risk).
It's an incredibly powerful, (yet dangerous) tool that I think newcomers to the space don't understand too well.
Here’s a graphic that explains it
Without Leverage: You start with $100 and buy $BTC. BTC does a 2x, and you now have $200. Profit = $100 ROI = 100% (Profit / initial investment) No leverage is being used here
Now suppose you borrow an extra $50 from the bank at 10% interest.
You now have $150 that you use to buy BTC.
Case 1: $BTC does 2x
BTC does a 2x, and you now have $300.
After returning the borrowed $55 ($50 principle + $5 interest) to the bank, you have $245.
Profit = $145 ROI = 145%
Case 2: $BTC dumps 50%
In the example above, you borrowed some money at 10%, but your investment appreciated by 100%, so you were able to amplify your returns.
Now let’s take a look at the risk side of things. What if BTC goes down by 50%?
Without borrowing: $100 —> $50, so your ROI = –50%
You start with $100. You borrow $50 at 10% interest.
You buy $150 of BTC. BTC goes down 50%.
You now have $75, and you owe $55 to the bank, leaving you with $20.
Loss = $80 ROI = – 80%.
Hopefully, this example illustrates how leverage can amplify both your risks and your returns.
Don’t be greedy.
If you do use leverage, be VERY conservative with it.
Mortgages are probably the most common form of leverage.
You are buying a house for $500k.
You put a 20% down payment on a house ($100k).
You borrow the other 80% ($400k) from the bank.
You are now leveraging an asset (house) worth $500k, having put down only $100k.
If the house price goes up 10% in 1 year to $550k. Profit = $50k ROI = 50% (minus mortgage interest)
If the house price goes down 10% in 1 year to $450k Loss = – $50k ROI = –50%
10% move = ± 50%.
Leverage is everywhere. Keep your eyes peeled, and you’ll see it all around. Examples:
- Options and futures are leveraged instruments for equities.
- Buying stocks on margin
- Companies borrowing money to fund operations
- Hiring employees
Hope you found this useful. It’s not directly about #Crypto or #DeFi like my usual threads, but it’s a very important concept, that a lot of people don’t understand well enough. Be careful with leverage.
In Crypto / DeFi, there are many ways to use leverage to boost your #DeFi returns
Here's a sneak peek: