It is now February 4, 2026, 2:00 PM.
Thinking back to the previously mentioned issue of volatility and leverage, my earlier view was that leverage can be reduced to volatility, as they are essentially the same in mathematical nature.
However, I have recently gained some new thoughts and understandings.
For traders, volatility is more effective than leverage. Making money through trading essentially relies on volatility. Without volatility, there is no price spread to speak of, and trading profits become impossible. Leverage, on the other hand, comes at a cost, which manifests as a linear increase in the nominal value of positions, meaning a linear increase in transaction costs.
This is easy to understand: a market with an inherent volatility of 10% using 1x leverage and a market with an inherent volatility of 1% using 10x leverage yield the same profit or loss from price spreads, but the transaction cost of the former is only one-tenth of the latter.
However, volatility does not arise out of thin air.
High leverage implies high trading demand, which affects the supply-demand balance, weakens liquidity, and thus increases market volatility.
High volatility, in turn, essentially provides low-leverage traders with free high-volatility opportunities. Therefore, this is fundamentally a form of transfer payment. High-leverage traders transfer opportunities to low-leverage traders by amplifying market volatility.
This transfer payment is the true cost of leverage.
If liquidity providers are also considered, this transfer payment becomes even more apparent. Liquidity providers earn transaction fees by providing liquidity, and the presence of high-leverage traders increases market volatility, thereby raising the frequency of trades and the total transaction fees. High-leverage traders are essentially providing free market volatility to liquidity providers, indirectly subsidizing their profits.
It can be said that high-leverage traders sustain low-leverage traders and liquidity providers.
Market Collapse and Recovery Cycle
Considering the various participants in the market, we can arrive at an interesting conclusion.
From the perspective of liquidity, speculators, investors, and market makers engage in a cyclical loop of market collapse and recovery.
First, let’s introduce the three types of participants:
- Investors: Buy low and sell high. They only buy when prices are low, hold assets for the long term, and wait for prices to rise to profit.
- Speculators: Chase rallies and sell offs. They seek short-term trading opportunities during market fluctuations, using leverage to amplify gains.
- Market Makers: Provide liquidity. They earn transaction fees by offering liquidity, without explicitly taking bullish or bearish positions.
The market undergoes the following cycle, starting from a stagnant, neglected market:
- Volatility Rises: Driven by events, the market begins to fluctuate, attracting the attention of speculators. Speculators enter the market, use leverage for trading, and push up market volatility. At this stage, market makers are at a low point because market volatility is too low, and trading volume is insufficient to attract them to provide liquidity. Therefore, speculators can easily move market prices, creating a high-volatility market. Market trends begin to form.
- Volatility Declines: As market volatility increases, market makers gradually intervene, providing liquidity to earn transaction fees. They profit by setting spreads between buy and sell orders but also bear market risk. At this stage, market liquidity begins to recover, and trading volume gradually increases. The intervention of market makers reduces market volatility because they offer more buying and selling options, mitigating sharp price fluctuations. As market makers intervene, volatility decreases, and the market enters a relatively stable state. Speculators may reduce leverage during this phase because lower volatility reduces trading opportunities. The influence of market makers increases, while that of speculators declines.
The stable operation of the market is as described above. If volatility remains at a moderate level, the market will stay stable. However, in reality, markets often experience sharp fluctuations, leading to cycles of collapse and recovery:
- Market Collapse: In certain situations, market volatility suddenly exceeds a critical threshold, triggering a chain reaction. Speculators may increase leverage, further pushing up volatility, while market makers may withdraw liquidity due to excessive risk. In such cases, market liquidity rapidly evaporates, forcing active traders to pay significant slippage to enter or exit positions. Market prices fluctuate wildly, causing market makers to further withdraw and wait. This creates a positive feedback loop, leading to a rapid market collapse. This collapse can manifest as a sharp rally or a sharp decline. However, after a sharp rally, the market often experiences a rapid decline due to profit-taking by investors and bullish speculators, making the pattern of a rally followed by a decline very common.
- Market Recovery: After a sharp decline, investors intervene heavily, stabilizing the market. Investors’ buying behavior absorbs selling pressure in the market, helping prices recover. As market prices rebound, market makers re-enter, providing liquidity and further stabilizing the market. Speculators may reduce leverage during the recovery phase, waiting for new trading opportunities. As the market stabilizes, volatility gradually decreases, and the market enters a new equilibrium.
- Market Death: It must be mentioned that if investors no longer intervene, the market could completely collapse to zero. Examples of delisted stocks and crypto assets going to zero are abundant. Market death means all participants lose confidence, market prices drop to zero, and all assets become worthless.
This narrative can explain sudden changes in the market. The academic world also uses Catastrophe Theory to explain sudden market collapses, but that’s a topic for another time.
