Less than a week ago, on the night of December 3 to 4, 2021, the price of Bitcoin fell very quickly from $56K to $42K, before rebounding rapidly to around $48K. For many investors, this rapid drop was simply due to the volatility of the Bitcoin price, which is a feature, not a bug.
So there was no visible reason for this.
For those who have been in the Bitcoin world for a longer time, but also for all traders, there was a reason for this sharp correction in the Bitcoin price. An invisible reason, if I may say so.
In the following, I will explain how leverage trading works and why it can cause this type of movement in the price of Bitcoin. This will help you to guard against it in the future and to better control your emotions when these downward movements occur.
Leverage trading allows you to commit to more Bitcoin than your cash would normally allow you to buy
As you know, trading platforms allow investors to buy Bitcoin with leverage. For those of you who don't know what this means, don't panic, I'll explain it to you.
Let's say the price of Bitcoin is $60K. You would like to buy a whole Bitcoin, but you only have $6K to spare. A trading platform offers you to buy a whole Bitcoin for $60K, but you only have to pay 10% of the price, or $6K.
This is a 10x leverage purchase. You only put in $6K of your own money, but you are committing to $60K.
If the price of Bitcoin rises by 10% from $60K to $66K, then you've earned $6K. You have doubled your stake. If the price of Bitcoin falls by 10%, from $60K to $54K, you have lost $6K, which is your entire initial stake.
Since you only bet 10% in our example, i.e. $6K, and below $60K-$6K, i.e. $54K, your bet falls to zero, the intermediary who allowed you to buy the Bitcoin with x10 leverage will have to put a “stop” sell order in the market at $54K.
The Whales use an old technique to clean up retail investors who have abused leverage trading
If the market drops to $54K, the platform will automatically liquidate your position. This is normal since your initial bet only covers a loss of $6K and below $54K, your loss exceeds your bet and there is no time to warn you to increase your bet to cover your losses.
When the market moves sideways, for example around $60K, you will have a multitude of stop orders at all levels below $60K to automatically close out leveraged positions if they fall.
And this is where it gets more interesting to understand what happened on the night of December 3rd to 4th 2021.
The Whales are going to use an old technique known in the traditional markets and which has been used a lot in the past, especially in the foreign exchange market. It is called “fetching the stops”. You are a Whale and you know that there are plenty of automatic sell orders below $60K.
Whales take advantage of the situation to enrich themselves at the expense of retail investors using leverage trading without mastering it
You are going to wait for a time when the market is “deserted”, hollow. For example, on the night between Friday and Saturday, at the beginning of the weekend. You sell a good amount of Bitcoin. Since the market is empty, your sales have a massive effect since there are no buyers in front of you.
The price of Bitcoin starts to fall.
As it falls, automatic sales are triggered, automatically accelerating the fall, which triggers other automatic sales that also accelerate the fall, and so on. We then see a cascade of sell-offs that causes the price of Bitcoin to fall sharply.
A leverage shakeout or even leverage flush is when the effects are as strong on the price of Bitcoin as they were on the night of December 3 to 4, 2021. The price of Bitcoin quickly fell to around $42K.
At $42K, the Whales who sold their Bitcoin at $60K and caused this downward panic was going to buy massively. They bought back at $42K which they sold a few minutes earlier at $60K. They even took the opportunity to go long on Bitcoin at $42K. They will either hold these positions or sell them at $48K in the process.
Leverage trading is to be avoided by 99% of investors in the Bitcoin world
While the Whales are taking advantage of this age-old technique to enrich themselves, the retail investors who had played the Bitcoin bull market with leverage are getting cleaned out. In this leverage flush from December 3 to 4, 2021, the amount of long positions that were liquidated reached $2.5 billion.
This episode is not the first of its kind, and it obviously won't be the last. As an investor in Bitcoin, you should avoid leverage trading if you don't know exactly what you're doing. Every year we see too many beginners losing a lot of money with this technique that they don't master.
As a long-term investor in Bitcoin, you must accept that this volatility only impacts the price of Bitcoin in the short term. If you know how to control your emotions, then you will not be impacted, as the price of Bitcoin will then rise again. It's just a matter of time, and therefore patience.
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