Known for their market volatility, cryptocurrencies can quickly and easily lead to liquidation, especially when investors lose their leveraged positions and their investments plunge into a negative balance, requiring them to sell their crypto assets when their position is forcibly closed. This usually occurs in crypto margin trading, where investors borrow money from a crypto exchange or broker to increase their funds or assets for trading. While the improvement in trade positions from the borrowed funds can result in higher potential profits, it’s a very risky move that can result in liquidation if the asset price drops drastically and you lose your initial margin or capital.
If you have insufficient funds to continue with a trade, and are unable to meet the minimum margin requirements for your leveraged position, the exchange may automatically close your position, resulting in a permanent loss of funds from your initial margin. This loss in liquidation can be partial or total, depending on the initial margin and the extent of the price drop. A partial liquidation takes place when a position is closed partially at an early stage to reduce the position and leverage of the investor, whereas a total liquidation occurs when nearly all of the initial margin has diminished due to the price drop.
To better illustrate the process of liquidation in crypto margin trading, here’s an example: Suppose you start with a $100 initial margin and 10x leverage. This means your total trading position is $1,000, of which $900 is borrowed from the exchange or broker. The extent of the leverage matches the extent of your profit or loss from the position. With 10x leverage, an asset price increase of 5% will provide you with a 50% profit. The same goes for a decrease in 5% of the asset price, which will lead to a 50% loss of your initial margin. The formula to calculate your profit or loss is as follows:
Initial margin × (% price change × leverage) = profit/loss
Based on the above calculation, a 10% decrease in the asset’s price will cause you to lose 100% of your initial margin. Before losing all of your initial margin, you may receive a margin call when you reach the liquidation threshold, so that you can decide if you wish to add more funds to your margin to keep your position open (or lose your initial margin entirely when the exchange or broker automatically liquidates your position). With the forced closure of your position, you may also be charged a liquidation fee by the exchange or broker, but you can avoid this fee if you close your position before it gets liquidated.
Liquidation often occurs when investors are enticed by higher leverage that can potentially bring them more profit, but fail to take into account the possibility of incurring more losses that may trigger liquidation as well. Therefore, it’s critical to adopt smart crypto trading strategies to avoid liquidation, whether starting with lower leverage or closely monitoring the margins and liquidation prices. Using a stop-loss order is another way to limit your losses, as the order automatically closes the position for investors when it reaches the stop price to prevent further loss. Investors can also consider insurance funds from exchanges to protect themselves against excessive loss.