Don't Be A Sucker

How to not blow up trading crypto with leverage

When I was in 9th grade, I moved to a new town to attend high school: Ocean Springs, Mississippi. It was on the Gulf Coast and right next door to Biloxi, home to several casinos.

Apparently, the casino culture bled over into my gym class - this is where I was first introduced to “shooting dice” in the locker room with my new classmates.

At first, I became fascinated with the game of craps as it seemed like one big math problem: Roll a 7 or 11 on the first roll (called the “Come” bet because the dice are “coming out”) and win, roll a 2, 3 or 12 and you lose. Roll anything else (e.g., a 6) and that number becomes your “point” for which you need to roll that number again to win. Roll a 7 or 11 before you point and game over, you lose.

Simple right?

Well, the casinos are not in the business of giving away money so they take something relatively simple and make it more complex.

Wow, look at all these new ways to bet on the dice roll! The field, hardway bets, one roll bets! I have some unfortunate news.

These are all sucker’s bets.

Take a one roll bet. Let’s say you want to bet that the next roll is a snake eyes (1 and 1). The payout is huge: 30:1! However, this is where you become a sucker.

See the odds of rolling snake eyes are actually 36:1 or put another way, you have a 1 out of 36 chance of rolling two 1s - there’s only one “1” on each individual die so 1/6 * 1/6 = 1/36.

But why is the casino only willing to pay you 30:1? Because over a long enough time horizon, the house will always win.

Crypto exchanges are not casinos, although as I mentioned at World Crypto Conference in Las Vegas (oddly enough) in 2019, crypto exchanges are marketing themselves very much like online casinos.

And much like casinos, exchanges have suckers bets too — leverage.

A trader in the Market Mercenaries chat recently asked about whether it was more profitable to buy and hold spot or trade the perpetual contract for the same asset.

There is no simple answer here and what follows is absolutely not financial or investment advice, but I have a relatively simple approach — don’t be a sucker.

Let’s say you have an account on FTX (or FTX US if you are a US citizen), are long $SOL (Solana) the actual token (commonly referred to as “spot” aka the literal asset itself, not some derivative of it) and you have a long/bullish bias on it. You can simply hold this asset in your portfolio and if the price goes up you make a profit. Investing 101.

Now, if you want to “juice” your returns you can use your $SOL spot as collateral and go long the perpetual contract as well, $SOL-PERP.

So far so good, right?

But this is where suckers get rekt.

There is an option on every major crypto exchange that offers derivatives trading - leverage.

Leverage enables you to trade with more size than if you were only using the money you had on hand.

For example, if you have $1M USD, 1.5x leverage enables you to trade like you have $1.5M, 2x leverage as if you had $2M, and so on. But what’s the rub? Well, you need to post collateral and maintain that level of collateral consistent with the leverage you are using. If not, say goodbye to your collateral - you will get liquidated.

There’s plenty of literature online about the math behind leverage but I will overly simplify it here: if you use 2x leverage and the price drops 50%, you get liquidated.

Put another way, if you don’t use any leverage and you just buy an asset you are effectively at 1x leverage — $1M of Bitcoin = 1x a $1M. In order for you to lose 100% of your investment, Bitcoin would need to trade to $0.00.

Now, if you long $2M worth of Bitcoin using 2x leverage on your $1M, then the price of Bitcoin from where you purchased would need to drop 50% for you to lose your $1M.

It raises the question - do you believe the price from the point of your purchase is going to drop 50%?

50% is a pretty big drop. Who’s really the sucker here, you may be asking yourself.

Well, these exchanges don’t just offer 2 or 3x leverage - they offer up to 125x leverage.

This is the sucker’s bet.

Crypto Twitter, Reddit, the legacy media, etc. all love to hype stories of crypto millionaires getting lucky by taking on massive leverage. What you don’t hear are the other 99% of times it didn’t work. The Boot may be one of the rarest people in crypto to pull off the impossible twice using high leverage but he is an anomaly; there are countless others who have gotten rekt over and over again using too much leverage.

Think about it this way: how do exchanges make most if not all of their money? By taking a commission on the transactions so their business model is tightly coupled to an increase in traders making more and more trades and what better way to entice them to trade more than the promise of potential huge gains by just using 50x leverage?

And this is where you become the sucker at the craps table.

As more and more people lever up, the forced liquidations tend to increase on sharp moves. Trading crypto is inherently volatile with daily or even hourly price swings of 20-30% being the norm so if don’t nail the bottom when you get long with 25x leverage your odds of winning are lower than rolling snake eyes at the craps table.

However, if you keep your leverage low for the majority of your trading, you won’t get to tweet your massive wins and contribute to the hall of fame of PnL porn but you will more likely end up making more money over the long term.

Chasing clout is not a recipe for success.

Few understand this.

Now you may be saying, “but Joe, I want to have some fun and ‘gamble’ every once in a while can’t I bet on the Field”? Of course, there’s nothing wrong with having a little fun at the craps table. I like to bet the hardways every once in a while but I know a priori that I’m making a sucker’s bet. Treat it as entertainment, not as a winning strategy.

The same is the case with leverage. You wanna roll the dice a bit? Create a subaccount, name it “YOLO”, and deposit less than 1% of your bankroll and go nuts with a 50x bet. I do from time to time for fun and I’ve been successful about 5% of the time.

So, are you feeling lucky?