๐Ÿง  Is 50x leverage high for a rates trade?

Capital efficiency has been a critical topic in crypto trading for a while. The community has embraced leverage, both profiting from it and getting burned every cycle. Statistically, an average crypto trader trades perpetual futures on 5-10x leverage, and while some traders prefer higher numbers, other traders tend to frown upon this as irresponsible risk-taking.

As the relationship between leverage, profitability, and risk depends on the instrument, we need to examine leverage more closely, specifically in the context of interest rate trading.

Let's look at the numbers.

Case study

BTC perpetual future funding rate on Binance currently stands at 0.01% every 8 hours (an equivalent of 10.95% APR).

Trader Bob believes an upcoming market announcement will send the market sentiment flying, and over the following period, the average rate will double today's value: 0.02% every 8 hours (or 21.90% APR).

Bob selects a Rho rate future that expires in 4 weeks, deposits USDT 1,000 worth of collateral, and goes long for USDT 50,000 size (notional).

Bob's leverage is simply the notional of the trade, divided by his collateral:

Leverage = Notional / Collateral = 50,000 / 1,000 = 50x

50x sounds like a lot, but let's calculate Bob's potential profits and losses, as well as his risk of liquidation.

DV01 and PnL impact

As shown above, Bob's new position has a DV01 of 0.383 USDT โ€” that's the impact of a one-basis-point movement of the rate on Bob's position value. This implies that a ยฑ1% market movement in APR terms would cost Bob's Long position ยฑ38.3 USDT. ยฑ10% will result in ยฑ383 USDT.

If Bob is right, and the rates will average 21.90% APR, Bob will profit about +456.42 USDT on his initial 1,000 USDT deposit in four weeks, a monthly return of over 45% (ex. fees).

Similarly, if the rates go against Bob by the same value and stay close to 0% for the holding period, Bob loses just over 45% of his 1,000 USDT deposit.

Liquidation risk

To be at risk of liquidation, Bob's remaining margin (initial deposit ยฑaccumulated PnL) should fall below the Liquidation Threshold level.

The Liquidation Threshold on Bob's position currently stands at 230.14 USDT.

This implies that Bob has to lose 1,000 - 230.14 = 769.86 USDT on a mark-to-market basis to be at risk of liquidation. Based on Bob's DV01, this loss would be the equivalent of โˆ’769.86/38.3=โˆ’20.1%-769.86 / 38.3 = -20.1\%market movement.

At 50x leverage, Bob has to lose approximately 77% of his initial deposit to be at risk of liquidation. That would require a rapid drop of c. -20% from today's 10.95%. The resulting rate that would put Bob's position at risk of delinquency would be negative 9%!

Margin calls and trader protection

Risk and potential losses are a part of a trader's life, and most traders are skilled enough to mitigate them, given the right amount of notice. The danger of high leverage on option or forex markets is that sudden market movements can potentially wipe out the trader's collateral in a matter of hours, sometimes even minutes.

However, in the example above, if the market starts moving very adversely against Bob, given the risk management measures that Rho has put in place to protect traders like him, Bob will have at least a couple of days to react before he is at risk of liquidation. Read more about these measures in this guide.

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