Liquidation, in fact, is a crypto apparition which typically happens when a crypto investor is unable to meet the margin requirements of the crypto exchange or the broker to use the leveraged positions.
This is a process which refers to the selling off of the crypto assets for cash in an event of a loss for minimizing its effects.
It usually happens when the market crashes.
However, this is a risk since you can lose your capital or the initial margin if the market moves in the opposite direction of your leveraged position which may result in a liquidation of your crypto assets.
Therefore, in order to keep the trading positions open, a trader needs to hold a specific percentage of the value of the position which is called the maintenance margin percentage.
If that is not fulfilled, the liquidation engine will take over the position of the crypto trader and liquidate resulting in the loss of the maintenance margin.
Through this article you will come to know the meaning of crypto liquidation, the specific reasons for crypto being so prone to liquidation in the volatile trading environment, and also the ways in which you can avoid such a situation.
What is Crypto Liquidation and How to Avoid It?
As said earlier, liquidation in a crypto space is a common occurrence due to the high volatility aspect of the crypto assets.
Though this volatility aspect of crypto is a concern for the regulators, it is a boon for the crypto investors and traders.
This is because the volatility of crypto offers a lot of opportunity to the investors and traders to make a significant amount of profits especially when it is compared to traditional investments asset classes such as commodities and stocks.
This usually happens through different derivative products such as:
These derivatives are actually contracts that allow the crypto traders to speculate on the future price of a coin underlying it.
These derivatives have gained a lot of momentum over the past few years, especially among the eager and enthusiastic retail investors who want to make the most out of their crypto trading strategies.
And, it is more seen in the form of margin trading, which, as said earlier, increases the profit potential but also comes with a high risk of the entire margin being liquidated.
Therefore, trading crypto with leveraged position is a very high risk strategy, and in fact, it is this high risk for which some countries such as the United Kingdom has banned the crypto exchanges from offering leveraged trading products to the new traders.
This saves them from losing their entire capital invested in crypto.
Liquidation in the crypto space is usually a forced closing of the position of a trader in the event of total or partial loss of the initial margin of the trader.
This means that that trader is unable to keep their positions open due to lack of funds.
In such a situation the exchange will close out the trader’s position automatically which will lead to a loss of funds for the investor.
The magnitude of this loss will however depend on the degree of price drop of that particular crypto asset as well as the amount of initial margin in place.
In specific situations it can even result in a complete loss of the investment.
Ideally, liquidations can be classified into two groups namely, partial liquidation and total liquidation. For instance:
Partial liquidation is a situation where the position is closed early on and partially in order to reduce the leverage used by the crypto trader as well as the position.
Total liquidation, on the other hand, refers to a situation where the entire position or the initial margin that the trader was using is closed out.
Liquidation can happen in both spot trading and futures trading.
In this aspect, you will need to calculate the maintenance margin. This is typically based on two specific elements such as:
- The leverage of the position and
- The average entry price.
You should typically take note of the price gap existing between the contract mark price and the liquidation price.
If the mark price approaches the liquidation price, the liquidation engine will take over the position.
In order to keep a track of the percentage required by the market to move in order to prevent your assets from being liquidated, you can use the following formula:
Liquidation % = 100 / Leverage
If it is found that the mark price of the contract reaches below the liquidation price when long or above it when short, the position of the trader will be summarily liquidated.
At this point it is important to know that a trader needs not use the entire capital as collateral to open a position for margin trading.
There are two specific types of leverage that you can go for such as – isolated margin and cross margin.
In the case of isolated margin, the collateral required by the exchange to make a transaction is restricted by the pledge only.
In other words, it is the pledge itself that will deter the exchange from withdrawing all your funds from the account in case of liquidation.
Isolated margin is a good option to follow for those traders who specifically hold one position only.
This helps the traders in this case to alter the leverage on its move even after a transaction is opened.
This will eventually increase the initial collateral of the trader from the balance amount in the account.
In the case of cross margin, which is also referred to as spread margin, the total balance of the trader or the maintenance margin is used to avoid liquidation.
This means that the loss incurred in one particular trade will be covered automatically by the profit made on another trade that may be opened at that particular instant.
This type of approach is more suitable for those traders who have multiple positions or trades open that involve several types of trading pairs at the same time.
How Does It Happen?
Liquidation is typically associated with margin trading or trading with leveraged positions.
In this process, where you need to deposit some funds to the crypto exchange called ‘initial margin’ is held as collateral.
This margin assures the exchange to recover the losses if the trades go south.
It is required to maintain this margin by the trader at all cost to keep their positions open.
The leverage offered by the exchange is typically calculated on the basis of the fund borrowed from the exchange with respect to the initial margin.
The degree of leverage offered usually determines the amount of profit or loss you can make.
You can calculate this by yourself using a simple formula, which is:
Initial margin × (% price movement × leverage) = profit or loss
This means that the losses will be magnified by the size of your leveraged position. When trading positions are liquidated, it is usually closed at the prevailing market price of the crypto asset.
Typically, when the leveraged position approaches the threshold of liquidation, you will get a ‘margin call.’
This is actually the demand made by the broker to put in more funds to your account to maintain your position and keep it open.
At this point, there are two things that can happen such as:
- You can put in more funds to your margin so that the leverage is brought back up and above the required leverage or
- The exchange or the broker liquidates your position automatically.
Add to that, the exchange will also charge you a fee for liquidation.
The main idea behind liquidation is to encourage people to make sure that they close their trades before the situation arises when it can be liquidated automatically.
A crucial aspect of leveraged trading is that it cuts both ways.
When you go for higher leverage you can surely make more money but at the same time even the slightest of negative movements in the price may result in a liquidation event.
Though there are a few specific crypto exchanges that may offer a maintenance margin of a fixed percentage of bankruptcy price which prevent partial liquidation, you should still limit your trades to a limit you can manage.
The liquidation process typically works in different ways depending on the risk limit.
For example, if you use the lowest risk limit the open order will be annulled on the contract if you set the position in an Auto Deposit Margin mode, depending on the features of the exchange.
However, if you do not meet the maintenance margin requirement the entire position will be liquidated since the liquidation engine will take it over at the bankruptcy price.
On the other hand, if you use a higher risk limit the system will try to bring it down to a risk limit which is in accordance with the current position and the open orders.
If there is any open order, it will be annulled on the contract. A ‘fill or kill’ order will be sent to reduce the MMR and the position value below the lower tier risk limit.
If it is not met, the entire position will be liquidated automatically by the liquidation engine at the bankruptcy price.
Liquidation price is when the leveraged positions are closed out automatically.
There are a few specific factors that may affect this price such as:
- The amount of leverage used
- The MMR or Maintenance Margin Rate
- The price of the specific crypto coin
- The position of the trader and
- The balance in the margin account.
Typically, it is the crypto exchange that will determine the liquidation price for you.
The eventual price can be the average of some of the major exchanges.
This price is actually determined automatically when a leveraged trading position is opened.
The liquidation process is triggered once the price of the crypto crosses the threshold of the liquidation price.
There are a few things that you should keep in mind with respect to the liquidation price in order to keep your positions open.
- The higher the leverage, the lower will be the percentage of change in price that may lead to liquidation of your position
- Not to use leverage more than 10x if you are experienced and not more than 2x if you are a beginner and
- To place the liquidation price below the opening price when you open a long position.
In view of that, if you open a short position liquidation will happen only in case the price of the coin reaches to a specific level which is more than the entry price.
At this point it is very important to note that just as crypto is very volatile, the liquidation price therefore can change at any point in time.
It will majorly depend on the conditions of the market.
Therefore, if you are planning to sell your Bitcoin or any other crypto coin, it will always be a prudent idea to check out the most recent liquidation price before you make your final decision.
By doing so you will be sure whether or not you are getting the best deal.
At this point it is good to know about the differences between a forced liquidation and a normal liquidation.
Typical liquidation and forced liquidation may be a bit confusing and you may tend to think that these two are the same.
However, it is not true because there are some distinct differences between them.
Typical liquidation refers to the process where assets are simply converted into cash.
Forced liquidation, on the other hand, in crypto trading indicates the involuntary conversion of the crypto assets into cash or its equivalents such as stablecoins.
Forced liquidation happens only when the trader is unable to meet the minimum margin requirement as set by the exchange to maintain the leveraged position.
In such cases, the position is closed by the third party, in this case the crypto exchange, and the assets of the trader are sold automatically in order to cover the positions.
However, in a regular liquidation process it is the trader who has to close their positions and cash out.
There can be several reasons for such cash out.
There is another major difference between normal and forced liquidation.
It is that in forced liquidations all open positions are closed at the same time.
However, in normal liquidation these are usually closed gradually.
The purpose of forced liquidation is to protect the traders from incurring further losses.
While this is a significant benefit, there is a notable disadvantage of it as well, mainly because all the positions are closed at the same time.
This may typically result in missed opportunities.
On the other hand, the standard liquidation process offers the traders more control over their positions because they are not closed all at once.
However, the significant downside of it is that it makes them vulnerable to incur higher losses if the market moves in the opposite direction.
In the crypto space, a forced liquidation may happen when you use leverage for both long and short positions.
This means that you borrow more coins than you hold currently with an intention to make higher profits by trading more coins rather than simply holding just a few of them.
However, when you start to lose the trade, it will call for a maximum margin requirement above the initial margin.
This means that the exchange or the broker will force you to pay them back the borrowed coins or equity as and when the leverage hits the multiplier.
Therefore, it is important to calculate and recalculate your positions continually to check whether or not there is any chance of the price bouncing back from the losing position.
One strike and you will suffer a loss since your position will be liquidated.
When the leverage multiplier is higher, the adverse movements will be smaller to liquidate your position.
This is because there will be a difference between the margin maximum and your initial margin.
When such a thing happens in a low liquidity market, which usually does often, it may cause a tumble because the other traders using leveraged positions will also be called as a consequence of your forced liquidation.
Stages of Liquidation
There are different stages of liquidation.
These stages are focused on when the crypto exchanges are not able to liquidate the positions ahead of the balance of the trader going negative.
These following methods are used by the exchanges to protect them from the losses of insolvent positions.
This is a fund maintained by the crypto exchange.
This allows the traders to make their profits from trades in full as well as ensure those traders who have gone bankrupt do not have to incur losses unnecessarily.
Socialized losses system:
This is a particular method that distributes the losses incurred by a bankrupt trader among all other profitable traders.
ADL or Auto-Deleveraging Liquidation is a method when the crypto exchanges choose the market positions of the traders depending on the leverage, priority, and amount of profit.
In this method the position is closed out automatically to cover the losses.
Tips to Avoid
Whether it is spot trading or margin trading with crypto, there is always a chance of losing money.
You may surely avoid liquidation by reducing leverage slowly.
However, you will need to keep a track of the liquidation prices in the first place for that and to know how close your position is not to be able to cover the margin.
On the other hand, some other useful strategies include and are certainly not limited to lowering leverage, using insurance funds, keeping an eye on the margins and lots more.
Well, here they are all compiled for you.
As said earlier, insurance funds are a very useful protective mechanism to reduce the effects of losses incurred in a trade.
Typically in margin trading, where funds and assets being liquidated is a commonplace, an insurance fund will surely cover the contract loss.
Any gains made in the situations when the position of a trader is liquidated at a price which is higher than the bankruptcy price, that is when the price of the losses of a trader is equal to the initial margin, it goes to the insurance fund.
On the other hand, when the liquidation price is lower than the bankruptcy price, that is when the price of loss is higher than the initial margin, the insurance fund covers the negative equity or deficit.
The main objective of the insurance funds is to restrict liquidation through ADL. And, these funds are typically replenished with the liquidated positions.
When you use a stop-loss order it will allow you to close your position if you want with a market order when you see that the price of the last trade has already reached the predetermined price.
This order will act as a safety net and not allow your potential loss to cross the entry price.
When you set up a stop loss, also known as stop order or stop-market order, you will need to input three specific things such as:
- The stop price, which is the price where this order will be executed
- The sell price, which is the price at which the specific crypto asset will be sold and
- The size, which refers to the amount of that specific crypto asset that you intend to sell.
However, if you feel that the market will move against you very quickly, you can even set the sell price lower than the stop price.
This will increase the likelihood of the position being filled.
It is very important to know how to place your stop loss correctly and where exactly to set it.
There is no golden rule for it, though it is good to choose a spread anywhere between 2% and 5%.
On the other hand, you may also set the stop loss just under low price swings that are more recent but make sure that it is not too low that your assets are liquidated before it is triggered.
Then, you should also consider the risks related to it along with the trading size in order to place your stop loss correctly.
Remember, your chances of being liquidated are higher if you use a higher leverage.
This is not recommended because it will expose your crypto assets to higher risks unnecessarily and even be liquidated if the exchange is known to manage liquidations more aggressively.
Therefore, the most effective and easiest way to avoid liquidation of your crypto assets is to set up a stop loss order correctly.
Liquidation exit approach:
Though insurance funds will protect you in the bankrupt situation when you incur losses, following the liquidation exit approach will allow you to prevent your trade from facing such risks in the first place.
When you have a proper exit plan in place it will surely help you a lot in minimizing the losses.
These tools will help you to close your positions before things move towards liquidation.
Some useful examples of a liquidation exit strategy include and are not limited to strategies such as:
This is a specific type of stop-loss order that is set up based on the direction and distance of the price of the last trade from the pre-set price.
This means that it will be triggered only when the last trade price reaches its peak and starts to move in one particular direction.
This will increase unrealized profits and limit the losses particularly when the price and the market move in your favor.
Monitoring the margin ratio:
If you monitor the margin ratio, you will also be able to avoid liquidation.
This approach will enable you to ensure that your margin never reaches 100%, and if it does, you can keep your position alive and open by adding more funds to it.
This will enable you to trade for long and not worry about liquidation risks.
Using lower leverage:
You may also use lower leverage to avoid liquidation instead of higher leverage for higher possibilities of gains.
It will be detrimental if you use higher leverage when you incur losses. Therefore, stick to lower leverage.
There are a few specific ways in which you can minimize the impact of liquidation.
For example, you can reduce the size of the leverage by increasing the margins.
This will ensure that the mark price is lower than the liquidation price.
However, if a liquidation process is set off by a specific crypto exchange that offers futures contracts, it will be cancelled by contract with the open orders in it.
This will free up the margin and therefore maintain the position.
Typically, the futures use the fair price marking model to avoid liquidation that may be triggered by illiquid markets or price manipulations.
This means that it will not affect the orders on other contracts.
The system will add the deficit margin to the position automatically provided it is in the Auto-Margin Deposit mode to prevent the position from being liquidated.
What Happens Next?
As and when your position is liquidated, you will lose your entire margin.
As said earlier the liquidation engine will close the position automatically at the liquidation price.
However, the insurance funds will be applicable in case the balance in the account falls and goes negative to cover the cost.
But, if this fund is not enough to cover the cost entirely, it will trigger liquidation and you will lose the specific amount of margin.
Therefore, with all these said, it is very important for you to understand that leveraged trading using borrowing funds is not at all a good strategy for the beginners.
It can multiple potential gains but can also amplify the losses.
Therefore, it is important that you use proper trading tools, keep an eye on the margin, and leverage sensibly.
It is essential to know about liquidation and the different ways to avoid it before you start trading with crypto.
Since leveraged trading can increase profit potential but also comes with a lot of risk, this is very important, as it is pointed out in this article.