What Is Crypto Liquidation & How Do I Avoid It?
Cryptocurrencies are known for their volatility. This makes them prime targets for liquidation. Liquidation, the bogeyman of crypto trading, occurs when an investor cannot meet the margin requirement for their leveraged position. Traders increase the funds they can trade with by borrowing from a third party — in this case, an exchange.
While leveraging or borrowing funds to increase trade positions can multiply potential gains, it’s a highly risky move. You could lose your initial margin or capital if the market moves against your leveraged position.
This article will delve into the meaning of crypto liquidation, how you can avoid it and what to do when it happens. We’ll also look at why volatile trading environments are more prone to liquidation. Let’s get started!
What Is Crypto Liquidation?
Liquidation refers to the process of selling off crypto assets for cash to minimize losses, especially in the event of a market crash.
However, in the crypto space, the term liquidation is mainly used to describe the forced closing of a trader’s position due to the partial or total loss of the trader’s initial margin. This happens when they cannot meet the margin requirements for their leveraged position — i.e., they have insufficient funds to keep the trade open. Margin requirements are often underfunded when there’s a sudden drop in the underlying asset’s price.
When this happens, the exchange will automatically close out the position, resulting in a loss of funds 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.
Liquidation can happen in both futures and spot trading. Though traders should be aware that when buying a contract, the price is derived from the asset instead of the asset itself. That translates to the fluctuation of the profit and loss when it’s converted back to the current asset’s price.
What Is Crypto Margin Trading?
Crypto margin trading is the process of borrowing money from crypto exchange to trade a higher volume of assets. This can provide the trader with increased buying power (or “leverage”) and the potential for greater profits. In other words, leverage refers to borrowing funds to enter a larger position than the own funds permit. However, it also carries more risk, as leveraged positions can be liquidated quickly if the market moves against you.
To open a trading position in margin trading, the exchange will require you to put up a specified amount of crypto or fiat currency (also known as the “initial margin”) as collateral. These funds help to insure the lender against loss if the trade goes south. While maintenance margin is referred to as the minimum margin required to keep a position open.
Leverage is calculated using the amount of funds you can borrow from an exchange relative to your initial margin. Let’s take a simple example. If you start with an initial margin of $1,000 and 10x leverage, that means you’ve borrowed $9,000 to increase your trading position from $1,000 to $10,000.
The degree of leverage also determines the potential of a trade to make or lose money. Using the example of 10x leverage above, if your asset’s price rises by 5%, you’ve gained $500 (or 5% of $10,000) from your trading position. That is, with just a 5% price increase, you’ve netted a profit of 50% of your initial $1,000 margin. Sounds lucrative, right?
But cryptocurrencies are notoriously volatile, and the price of your asset could tumble at a moment’s notice. So continuing with the example above, with a 5% drop in your asset’s price, you’ve lost $500, or 50% of your initial margin, which translates to a 50% loss.
The objective of trading is to make a profit. The formula for calculating how much you stand to make or lose when using leverage is simple:
Initial margin × (% price movement × leverage) = profit or loss
One important note about crypto margin trading: When positions are liquidated, they’re always closed at the current market price. Your losses are magnified by the size of the leveraged position. In other words, if the trader loses $1,000 out of the $10,000 open position, the trader lost his entire initial margin. So it’s critical to be aware of the risks involved before borrowing any money to trade cryptocurrencies.
How Does Crypto Liquidation Happen?
Liquidation happens when an exchange or brokerage closes out a trader’s position because it can no longer meet margin requirements. Margin is the percentage of the total trade value that must be deposited with the broker to open and maintain a position.
When a trader’s margin account falls below a level previously agreed upon with the exchange, positions will automatically start liquidating. When your leveraged position reaches the liquidation threshold, you’ll face a “margin call,” which means you need to put up more margin. Liquidation tends to happen more often on futures contracts, where traders use higher amounts of 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 example of a $1,000 initial margin, let’s say you entered a trade with 10x leverage, which means your leveraged position is now $10,000 — that is, $1,000 of your own money and $9,000 which you’ve borrowed from the exchange.
Let’s say your BTC slipped by 10%. Your position now is worth $9,000. Should the dip continue, and the position’s losses increase, it would be applied to the borrowed funds. To avoid losses to the borrowed capital, the exchange would then liquidate your position to protect the money lent to you. Your position is closed — and with it, your initial capital of $1,000 is lost.
That’s not all. Exchanges will typically charge you a liquidation fee. The idea is to encourage traders to close their positions before they’re liquidated automatically.
A critical point to know is that leverage cuts both ways: Higher leverage will make you more money when the trade goes well, but only require a slight negative price movement to trigger a liquidation event. For instance, a trade position with 50x leverage will only take a price slide of 2% to initiate a liquidation.
However, there are other instances where exchanges like Bybit offer a maintenance margin that is fixed at 0.5% of the bankruptcy price instead of the entry price. That also means, a trader’s position will not be partially liquidated but will only be liquidated if the initial margin has 0.5% left. Still, if you must use leverage, you may want to limit yourself to an amount you can manage.
Liquidation Price Explained
The liquidation price is the point at which your leveraged positions are automatically closed out. A few factors that affect this threshold include leverage used, maintenance margin rate, cryptocurrency price, and the remaining account balance. Exchanges will calculate the liquidation price for you, which may be an average taken from several major exchanges.
When the price of your cryptocurrency crosses the liquidation price threshold, it triggers the liquidation process. Cryptocurrency prices are constantly changing, so it’s important to stay on top of the latest news and make sure your positions are still making a profit. Otherwise, you may find yourself automatically liquidated at a loss.
Examples of Bitcoin Liquidation
A trader may need to liquidate their Bitcoin to cover a short position, or to meet other financial obligations. When this happens, the trader will usually sell their Bitcoin at the current market price, regardless of whether it’s above or below the original purchase price. However, in some cases, a trader may be forced to sell their Bitcoin at a price below the market rate. This may end up being the liquidation price, and it’s usually determined by the exchange on which the Bitcoin is being 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’s important to note that the liquidation price can change at any time, depending on the current market conditions. So if you’re thinking about selling your Bitcoin, it’s always a good idea to check the latest liquidation price before making a final decision. By doing this, you can make sure that you’re getting the best possible deal.
Forced Liquidation vs. Liquidation: Differences
The term “liquidation” simply means converting assets to cash. Forced liquidation in crypto trading refers to an involuntary conversion of crypto assets into cash or cash equivalents (such as stablecoins). Forced liquidation occurs when a trader fails to meet the margin requirement set for a leveraged position. When this condition is met, the exchange sells the trader’s assets automatically to cover their positions.
The main difference between liquidation and forced liquidation is that in a forced liquidation, the
trader’s positions are closed automatically by a third party (like the exchange), while in a
regular or voluntary liquidation, the trader has to close them. A trader can decide to cash out a cryptocurrency trade for various reasons.
Another key difference is that in a forced liquidation, all positions are closed at the same time, while in voluntary liquidation, they can be closed gradually.
A forced liquidation protects traders from incurring any additional losses. However, it can also be a disadvantage, because all positions are closed at the same time, which can lead to missed opportunities. A regular liquidation, on the other hand, gives traders more control over their positions as they can close them gradually. 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.
An insurance fund is a reserve pool of funds that acts as a protective mechanism against excessive loss. It is used to cover the contract loss. So, when a trader’s position has been liquidated at a price better than the bankruptcy price (that is, the price at which a trader’s losses equals their initial margin), any gains go to the insurance fund.
On the other hand, if the liquidation price is less than the bankruptcy price, the position’s loss will have exceeded the trader’s initial margin. The insurance fund will then cover this deficit (or negative equity).
For example, John and Alice opened different BTC long positions with a bankruptcy price of $40,000 and $39,500 respectively. 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 are safety nets that protect bankrupt traders from unfavorable losses. However, using liquidation exit strategies can prevent this risk in the first place. The purpose of an exit plan is to minimize the amount of money lost.
Examples of liquidation exit strategies include using limit, trailing stop-loss or stop-loss orders to close out positions before liquidation occurs.
Stop-loss: Using this stop-loss order means the trader chooses to close the position with a market order once the last traded price reaches a pre-determined price. Stop-loss orders act as a safety net to limit the potential loss that crosses the entry price.
Trailing stop-loss: This refers to setting a stop-loss order following the last traded price at a pre-set price’s distance and direction. 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 margin.
The Bottom Line
Before jumping into crypto trading, be sure you understand what liquidation is and how to avoid it. Crypto liquidation occurs when an investor cannot meet the margin requirement for their leveraged position. Traders increase the funds they can trade with by borrowing from an exchange.
While leveraging or borrowing funds to increase trade positions can multiply potential gains, it’s a highly risky move, and can equally amplify your losses. Nevertheless, you can avoid liquidation by keeping an eye on your margin, leveraging reasonably, and using trading tools such as stop-loss and limit orders.