How To Get Leverage On Your Ideas

One of the ways that I knew crypto was in the midst of a stupid crazy, eye-popping, slap-ya-momma-silly type of bubble last year was by the amount of leverage available to retail investors. If you aren’t a degenerate gambling addict (aka a Robinhood user), you may be unaware of how leverage works. This is where traders will put down some money and then a third party will loan them some multiple of that. When it works, it means you get to capture lots of profit on a larger position than you had the initial cash for. The formula is simple: 

Outcome = (amount of money required to open a position) x (% price movement) x (leverage)

Basically, you are required to put down a certain percentage of an asset’s value, then the third party will give you some money to cover the rest of the position, and then you pray to God that the numbers go up. Trading using leverage acts as an outcome multiplier. Little moves in asset prices can mean big investment outcomes in either direction. Win big, lose big. Traders use this tool because it allows them to magnify smaller price movements (e.g., a 2% swing can be a big deal if you are levered up enough), but they also use it because it allows for an outsized impact. Investing is a scale sport, and if you don’t have lots of cash, using leverage allows you to trade as if you do.

In a simplified example, imagine having $1,000 to invest in a stock, then borrowing $100K to amplify your investment. If the stock goes up 5%, your gain is $5K instead of $50—but if it goes down 5%, your loss is also $5K instead of $50. 

In a regulated, normal-world security market, the U.S. government enforces a 2x leverage limit. In contrast, crypto exchanges regularly offer up to 100x leverage. It is super, super dangerous to play with and at scale can lead to horrendous societal outcomes. The market crash of 1929 was partially driven by the rampant use of unregulated margin trades. There are numerous horror stories on Reddit of people losing millions over the course of several months using similar tools. Or as Warren Buffet said in 2010,

"It gets down to leverage overall…I've always said, ‘If you're smart, you don't need it; and if you're dumb, you shouldn't be using it.’"

Note: My finance professor at BYU once called Wall Street “Las Vegas for Mormons.” The faith of my forebearers famously prohibits gambling but you’ll still find my clean-cut Mormon brethren populating every major bank in the world, happily gambling away guilt-free on the stock market. I wonder what percentage of crypto trades are done by Diet Coke-shotgunning former missionaries? 

That unsophisticated investors have 50 times more leverage available in crypto versus stock markets is, to me, a clear indicator of an asset class that is so wildly volatile that it obviously hasn’t settled into the more understandable rhythm of traditional investments. You could argue that this craziness is the result of ponzi schemes, lack of inherent value, early market jitters, or whatever, but I think a part of it is the result of an undiscussed power of the internet—leveraged thoughts.