What does liquidation in crypto trading mean?
One of the most dangerous and attractive aspects of the crypto is the industry’s highly volatile nature. The crypto markets are open all the time, which means these volatile swings can occur at any given period. While this can be great for traders, it can also cause problems, such as trade liquidations.
Liquidation is one of the prime threats to crypto traders who trade with leverage. This guide will explain what it is, why it happens and what types of liquidation there are. Traders who are thinking about engaging in margin trading, with leveraged positions, need to learn about liquidation first.
What are crypto liquidations?
Liquidation is a process that can occur when an investor takes a leveraged position. The liquidation process means that traders are forced to close their position. The trader can suffer a partial, or even total loss of their initial margin. In other words, they cannot meet the margin requirements for the leveraged position. They simply have insufficient funds and cannot keep their trade open.
In a situation like this, the exchange automatically closes the trader’s position. Unfortunately, this causes traders to lose funds. The severity of the loss, depends on the initial margin and the price drop.
Why do crypto traders use leverage?
Trading with leverage allows traders to earn sizable profits even from the smallest market price changes. Leveraged trading means that the traders use only a portion of their own funds, the rest of which is borrowed from the exchange.
Of course, before the exchange lends you the funds, it will require collateral. This collateral is known as the initial margin. However, while this all sounds highly beneficial, it’s very risky. Even a small mistake can lead to losses of the borrowed funds, which also means the loss of your collateral. This is why traders have to take precautions against sudden price changes, which is where risk management comes into play.
If the price changes suddenly and you cannot meet the margin requirements — the forced liquidation process takes place. With leveraged trading, this can happen extremely quickly, before the trader gets a chance to react.
Before they liquidate accounts, exchanges carry out margin calls. A margin call is a demand from the exchange for you to deposit extra funds. In doing so, you can prevent the closing of your position. However, if you ignore the margin call, or you don’t have additional funds to add, the trade will be liquidated.
How do crypto liquidations happen?
Liquidations occur when brokerages or exchanges close a trader's position. This will only occur when the market moves in the opposite direction to the trade and the trader no longer meets the margin requirements. In other words, their collateral is too small in comparison to the suddenly increased risk.
When a situation like that occurs, the exchange makes the margin call, inviting the trader to deposit more money. If they choose not to do this, their account will be liquidated. This happens automatically when the trader’s position reaches the liquidation price.
One detail we’ve not mentioned so far, is that exchanges also charge a liquidation fee. This is something that the exchanges do on purpose, to ensure that traders close their position in time. In other words, it is better for everyone if the trader closes the position before it is automatically liquidated.
What is the liquidation price?
It’s imperative that traders are aware of their trades' liquidation price. The liquidation price is the point at which the trader’s leveraged positions are closed automatically. There are no more negotiations or opportunities and liquidation happens on its own.
The liquidation price is not a fixed price, but instead, depends on a number of factors. These may include the leverage used, crypto price, remaining account balance, maintenance margin rate, etc.
Types of liquidation
When it comes to liquidation, there are two types. The main difference between them concerns the extent to which your trading positions are closed, and whether the liquidation is forced or voluntary. The two types include:
Partial liquidation
Partial liquidation is a type of liquidation that takes place when only a portion of your position is closed. This is done to reduce risk exposure. Typically, this is a voluntary liquidation, where the trader doesn’t lose their entire stake.
Total liquidation
A more severe type of liquidation is called total liquidation. This is the type that involves selling your entire trading balance in order to cover losses. Total liquidation is typically forced liquidation, which means that the trader failed to meet the margin requirement, even after the margin call. In this situation, the exchange reacts without further warnings, and automatically closes the positions.
It is worth noting that there are certain cases where the liquidation process might lead to a negative balance. Exchanges tend to cover such losses as well, often through insurance funds or other methods. Insurance funds are the most popular method, however, this means that exchanges use funds that act as a type of protection for themselves.
If the situation is severe enough for the liquidation price to surpass the initial margin, this leads to bankruptcy. In such cases, the insurance fund absorbs the loss and protects traders from obtaining a negative balance.
How to avoid liquidation?
Fortunately for crypto traders, there are two primary methods of mitigating the risk of liquidation.
1. Determining the risk percentage
The first method of avoiding liquidation concerns the risk percentage. This method requires traders to make a decision on the amount of money that they’re willing to allocate towards the trade. In addition to that, traders must decide on the percentage of their trading account that they are willing to risk. This is part of risk reduction. According to experts, traders should only risk 1% to 3% of their account per trade. If they only risk 1% of their account, they would have to lose 100 consecutive trades to lose everything. Even in the crypto industry, this is a highly unlikely scenario.
2. Always using a stop-loss
The second option is to use a stop-loss. Using a stop-loss can be very helpful for traders. It can significantly reduce the amount of money you would lose if the trade was to go wrong. For example, you could set a stop-loss order at 2% under the entry price. If the market suddenly turns, you would experience very limited losses.
This is an important part of risk management, especially when it comes to margin trading. Remember, the crypto market is a highly volatile environment and prices can crash within minutes. If you aren’t paying attention, you can easily miss your chance to exit your position safely. This is why risk mitigation is absolutely crucial for safe trading.
Crypto liquidation: A threat that traders must remember
The Liquidation of a trade is typically conducted by the exchanges themselves, which is why the process is commonly referred to as forced liquidation. This is common whilst trading with leverage, especially when the liquidation risk is quite high. Crypto liquidation can result in losses for the traders, this is why it’s a process that traders must understand.
Of course, liquidation risk can be reduced. There are methods of risk reduction, or risk mitigation, such as always using a stop-loss order. This can be somewhat tedious, but in the grand scheme of things, it’s worth it.
FAQs
What are crypto liquidations?
Crypto liquidation is a process during which a trader’s assets get turned into cash. This happens during margin trading, when the market takes a sharp, unexpected turn.
What are the largest crypto liquidations?
The largest type of crypto liquidation is total liquidation. It involves selling of your entire trading balance just to cover losses.
How do you avoid liquidation in crypto?
There are ways of avoiding liquidation in crypto. Two of them, to be exact, where one involves determining risk percentage and the other using a stop-loss order.
Is liquidation good or bad?
Liquidation can be good or bad, depending on the context. Good liquidation happens when the investor exits a position on purpose to realize profits. However, if it is a forced liquidation, conducted automatically by the exchange — that is always bad.
Is Bitcoin easily liquidated?
Bitcoin is the most popular and one of the most traded crypto assets. It is also very volatile, and its price makes massive fluctuations. As such, it can get liquidated easily during volatile markets.
