Have you ever wondered how to trade using more money than you own? If you have and you’re new to DeFi, this tutorial is for you!
In the financial world, you use something called “leverage” to trade using more money than you own. Generally speaking, in order to access leverage, the first thing you need to do is to deposit some assets to an exchange to serve as collateral. Then, depending on the financial products that you’re trading, different ways are used to create leverage.
In the case of DeFi, there are three main types of leveraged product with different mechanisms to create leverage:
- Margin Trading,
- Perpetual Contracts, and
- Leveraged Tokens.
Below, we’ll walk you through each one of them. Feel free to skip any section that you’re already familiar with.
- Margin trading
The way margin trading works is that, on one hand, there are lenders who lend out their tokens and receive interest in return; on the other hand, there are margin traders who deposit assets as collateral to borrow tokens from the lenders to trade with leverage.
Platforms like Fulcrum, Marginswap, and Sushiswap’s Kashi enable users to do margin trading entirely on-chain.
Trades for margin trading are fully funded, unlike perpetual contracts (see below). Fully funded as in, if a trader longs 2 ETH, under the hood, this trader borrows USDC from lenders and buys 2 ETH on the spot market of an exchange.
- Perpetual Contract
A perpetual contract is a derivative that allows traders to speculate an asset’s price movement without holding the asset itself. Usually, traders use USDC, or other stablecoins, as the collateral to open positions for an asset with leverage. If the asset’s price goes the same way as the position, the trader will receive more USDC when they close the position; otherwise, if the price moves against them, the trader will receive less USDC when closing the position.
Unlike margin trading where each trade is fully funded, the leverage for the perpetual contract comes from the contract itself (it’s a derivative after all!). You can check this article to learn more about perpetual contracts.
Players in this category include Perpetual Protocol, Futureswap, and Leverj.
- Leveraged Token
The main idea behind leveraged tokens is that it’s a token that gives its holder price exposure to an asset, with leverage within a certain range. If a leveraged token gives its holder 2x price exposure to ETH, then if the ETH price increases by 10% today, the price of that leveraged token should increase close to 20%.
A leveraged token can be fully funded like Index Coop’s ETH2x where 1 ETH2x token contains approximately two ETH (hence it’s not a derivative!), or it’s partially funded (it’s a derivative) like Charm Finance’s Cube Tokens.
Trading with leverage also comes with greater risks. As such, we recommend you check out this article to learn more about liquidation and how to avoid it.