Crypto Liquidation 101: How to Avoid Crypto Liquidation
Cryptocurrencies are known for their volatility. As a result, they are prime targets for liquidation. The feared bogeyman of crypto trading is liquidation, which occurs when an investor is unable to pay the margin requirement for their leveraged position. Traders boost their trading capital by borrowing from a third party — in this case, an exchange.
While leveraging or borrowing cash to boost trade positions might multiply potential earnings, it is a high-risk activity. If the market goes against your leveraged position, you could lose your initial margin or capital.
This article will explain what cryptocurrency liquidation is, how to avoid it, and what to do if it occurs. We’ll also look at why volatile trading situations are more vulnerable to liquidation. Let’s get started!
What Is Crypto Liquidation?
Liquidation is the process of selling crypto assets for cash to limit losses, especially in the case of a market meltdown.
In the crypto sector, however, the term liquidation is mostly used to describe the forced closing of a trader’s position due to a partial or whole loss of the trader’s initial margin.
This occurs when they are unable to match the margin requirements for their leveraged position, i.e., they do not have enough funds to keep the transaction open. When the price of the underlying asset falls suddenly, margin requirements are frequently unfunded.
When this occurs, the exchange will close out the trade automatically, resulting in a dollar loss for the investor. The severity of this loss will depend on the initial margin in place and how much the price drops. In some cases, it can lead to a total investment loss.
Liquidations can be categorized into partial and total liquidation. For example:
Partial liquidation: Liquidation that closes a position partially early on to reduce the position and leverage used by a trader.
Total liquidation: Closing a position nearly all of the initial margin of a trader has been used.
Both futures and spot trading can experience liquidation. Traders should be aware, however, that when purchasing a contract, the price is generated from the asset rather than the item itself. This results in a variation in profit and loss when converted back to the current asset’s price.
What Is Crypto Margin Trading?
The technique of borrowing money from a cryptocurrency exchange to trade a larger number of assets is known as crypto margin trading. This can provide the trader with more buying power (or “leverage”) and the possibility for higher earnings. In other words, leverage is the use of borrowed funds to enter a larger position than one’s funds allow. However, it bears higher risk because leveraged holdings can be quickly liquidated if the market goes against you.
To create a margin trading position, the exchange will need you to put up a certain amount of crypto or fiat currency as collateral (also known as the “initial margin”). These monies aim to protect the lender if the deal fails. While maintenance margin is referred to as the minimum margin required to keep a position open.
The amount of funds you can borrow from an exchange about your initial margin is used to calculate leverage. Let us look at a basic example. If you start with a $1,000 margin and leverage 10x, you’ve borrowed $9,000 to expand your trading position from $1,000 to $10,000.
The degree of leverage also influences whether a trade can win or lose money. Using the 10x leverage example above, if the price of your asset rises by 5%, you’ve profited $500 (or 5% of $10,000) from your trading position. That is, with just a 5% price increase, you’ve made 50% of your initial $1,000 profit. Sounds appealing, doesn’t it?
However, cryptocurrencies are notoriously volatile, and the value of your asset could drop at any time. Continuing with the scenario above, a 5% reduction in the price of your asset results in a loss of $500, or 50% of your initial margin, resulting in a 50% loss.
The goal of trading is to make money. When utilizing leverage, the calculation for estimating how much you stand to gain or lose is straightforward:
Initial margin × (% price movement × leverage) = profit or loss
One thing to keep in mind concerning crypto margin trading: holdings are always liquidated at the current market price. The amount of the leveraged investment magnifies your losses. In other words, if the trader loses $1,000 on a $10,000 open position, he loses his whole starting margin. As a result, before borrowing money to trade cryptocurrencies, it is vital to be informed of the hazards involved.
How Does Crypto Liquidation Occur?
When an exchange or brokerage closes out a trader’s position because it can no longer meet margin requirements, this is referred to as liquidation. Margin is the proportion of the total trade value required to initiate and maintain a position with the broker.
When a trader’s margin account goes below a pre-agreed-upon amount with the exchange, positions are instantly liquidated. When your leveraged position hits the liquidation threshold, you will be faced with a “margin call,” which means you will be required to put up extra margin. Liquidation occurs more frequently on futures contracts when traders utilize more leverage.
At that point, there are two options: Either you can add funds to your margin to bring your leverage back up above the leverage requirement, or the broker will automatically liquidate your position.
Continuing with our $1,000 starting margin example, suppose you placed a transaction with 10x leverage, which means your leveraged position is now $10,000 — $1,000 of your own money plus $9,000 borrowed from the exchange.
Assume your BTC fell by 10%. Your current position is worth $10,000. If the downturn continues and the position’s losses worsen, it will be applied to the borrowed funds. To protect the borrowed funds and avoid losses, the exchange would then liquidate your position. Your position is closed, and your $1,000 original capital is gone.
That isn’t everything. A liquidation fee is usually charged by exchanges. The goal is to urge traders to close their positions before they’re liquidated automatically.
It is crucial to understand that leverage works both ways: When the deal goes well, higher leverage will make you more money, but a minor negative price movement will trigger a liquidation event. A trade position with 50x leverage, for example, requires only a 2% price drop to trigger a liquidation.
However, in some cases, exchanges offer a maintenance margin of 0.5% of the bankruptcy price rather than the entry price. That also indicates that a trader’s position will not be partially liquidated, but will be liquidated only if the initial margin has 0.5% remaining. Still, if you must utilize leverage, you should keep it to a manageable amount.
Liquidation Price Explained
Your leveraged investments are immediately closed out at the liquidation price. This threshold is affected by several factors, including the leverage used, the maintenance margin rate, the cryptocurrency price, and the remaining account balance. Exchanges calculate the liquidation price for you, which may be an average of multiple major exchanges.
The liquidation procedure begins when the price of your coin passes the liquidation price barrier. Cryptocurrency values are continuously changing, so it’s critical to stay up to date on the newest news and ensure your positions are still profitable. Otherwise, you risk being automatically liquidated at a loss.
Examples of Bitcoin Liquidation
To cover a short position or meet other financial commitments, a trader may need to sell their Bitcoin. When this occurs, the trader will usually sell their Bitcoin at the current market price, whether it is more or lower than the original buy price. In some situations, though, a trader may be obliged to sell their Bitcoin at a price lower than the market rate. This may become the liquidation price, and it is normally established by the exchange where the Bitcoin is sold.
In early January, when Bitcoin fell below 43k, over $812 million of crypto futures were liquidated, resulting in large losses for long crypto traders. This happened because of a partial or total loss of initial margin for traders.
It should be noted that the liquidation price can vary at any time, depending on market conditions. So, if you’re thinking about selling your Bitcoin, always check the most recent liquidation price before making a final decision. You can ensure that you are obtaining the greatest possible deal by doing so.
Forced Liquidation vs. Liquidation: Differences
The term “liquidation” simply refers to the process of transforming assets into cash. In cryptocurrency trading, forced liquidation refers to the forcible conversion of crypto assets into cash or cash equivalents (such as stablecoins). When a trader fails to meet the margin requirement for a leveraged position, the position is forced liquidated. When this condition is met, the exchange instantly sells the trader’s assets to cover their positions.
The fundamental distinction between liquidation and forced liquidation is that in forced liquidation, a third party (such as the exchange) immediately closes the trader’s holdings, whereas, in regular or voluntary liquidation, the trader must terminate them. For a variety of reasons, a trader may opt to cash out a Bitcoin trade.
Another significant distinction is that in forced liquidation, all positions are terminated simultaneously, whereas in voluntary liquidation, they might be closed gradually.
A forced liquidation prevents dealers from incurring more losses. It can, however, be an advantage because all positions are closed at the same time, which can result in missed opportunities. This also means, however, that they’re more exposed to losses if the market moves against them.
How to Avoid Crypto Liquidation
While there’s always a chance you’ll lose money on a trade, employing smart trading strategies such as using lower leverage and monitoring margins can help a trader avoid liquidation. Crypto exchanges also offer insurance funds as a way of minimizing trading losses.
Insurance Funds
An insurance fund is a reserve pool of funds that serves as a safeguard against excessive loss. It is used to compensate for contract losses. So, when a trader’s position is liquidated at a price higher than the bankruptcy price (that is, the price at which a trader’s losses match their starting margin), any profits are transferred to the insurance fund.
If, on the other hand, the liquidation price is lower than the bankruptcy price, the loss on the position will surpass the trader’s initial margin. This deficit will subsequently be covered by the insurance fund (or negative equity).
For example, John and Alice each opened a BTC long position with a bankruptcy price of $40,000 and $39,500. They both have a liquidation price of $40,200, so when they get liquidated, John is liquidated at $40,000 thus taking away from his insurance fund while Alice is liquidated at $39,500 with the add-on of the insurance funds based on the last traded price of $39,800.
Liquidation Exit Strategy
Insurance funds serve as safety nets for insolvent merchants who suffer negative losses. However, adopting liquidation exit tactics can avoid this risk entirely. The goal of an exit strategy is to reduce the amount of money lost.
Exit techniques for liquidation include utilizing limit, trailing stop-loss, or stop-loss orders to shut out positions before liquidation.
Stop-loss: When a trader uses this stop-loss order, he or she chooses to close the position with a market order after the last traded price reaches a predetermined price. Stop-loss orders serve as a safety net, limiting potential losses that exceed the entry price.
Trailing stop-loss: This refers to placing a stop-loss order at a predetermined distance and direction from the previous traded price. So when the last traded price reaches the peak and only moves in one direction, it’ll then trigger the trailing stop. Thus limiting the losses and increasing unrealized gains when the market price moves in your favor.
Reducing leverage, even slowly, is also a way to combat liquidation. However, the first step is keeping track of liquidation prices, and of how close your positions are to not being able to cover the margin.
Conclusion
Before you start trading cryptocurrency, I always advise my audience to DYOR. Make sure you understand what liquidation is and how to avoid it. When an investor is unable to meet the margin requirement for their leveraged position, they must liquidate their cryptocurrency. Traders enhance their trading capital by borrowing from an exchange.
While leveraging or borrowing cash to enhance trade positions can multiply prospective rewards, it is also a high-risk activity that can exacerbate your losses. However, you can avoid liquidation by monitoring your margin, leveraging prudently, and employing trading tools such as stop-loss and limit orders…
