Liquidation is one of the most important and often misunderstood ideas in the crypto world, especially when it comes to leveraged positions. Liquidation in crypto is when an exchange or broker makes a trader close their leveraged position against their will.
This happens when the trader’s collateral, or margin, drops below the platform’s minimum maintenance margin level. It’s a way to keep the trader’s losses from going over their margin balance and to keep the exchange from having to pay for those losses.
Therefore, if you want to do leveraged margin trading in crypto, you need to know what liquidation is. Liquidation has a big effect on both the individual trader and the overall stability of the crypto market liquidity.
You need to know how to do this automated risk management process before you try to trade cryptocurrency. Join us in this blog as we explore the basics of margin trading, examples of crypto liquidation, who benefits from it, and key steps to minimize it. Let’s start!
What Is Margin Trading?
Margin trading is a way to trade in which you borrow money from an exchange or broker to give yourself more buying or selling power. This lets you open a position that is much bigger than the money you actually have, which is called leverage.
The money you put up to open the position is called the margin or collateral. For example, if you have a $1,000 margin and 10x leverage, you can open a $10,000 position. The main goal of margin trading is to make possible profits bigger. But it also greatly increases the risk, since losses are also increased by the same amount.
You need to keep a minimum amount of money in your account, called the maintenance margin, to keep the position open because of this higher risk. If you don’t meet this requirement, you will be liquidated right away.
At What Margin Level Do You Get Liquidated?
If your current margin level goes below the exchange’s required maintenance margin level, you will be liquidated. The margin level is a ratio that tells you how healthy your leveraged position is.
The exact formula may be a little different on different exchanges, but it usually compares the value of your equity (your funds) to the value of the maintenance margin that you need for your open positions.
When your equity (the value of your collateral minus any losses) hits the maintenance margin, the exchange starts the process of liquidation. People often say this as a percentage.
For instance, if your maintenance margin is 5% of the value of your position and your initial margin was 10%, a small drop in the price of the asset could cause a liquidation event. It is very important to understand this process to avoid crypto liquidation.
What Is an Example of Crypto Liquidation?
To show what crypto liquidation is, think of a made-up example. Let’s say a trader opens a position on Bitcoin for long liquidation (which means they think the price will go up).
- Setting Up: The trader has $2,000 of their own money (margin) and uses 10x leverage to buy $20,000 worth of BTC.
- The exchange needs a maintenance margin level of 5% of the position value, which is $1,000 ($20,000 * 0.05).
- Price Drop: If the price of Bitcoin goes down by 5%, the trader’s $20,000 position loses $1,000.
- Liquidation: The trader’s first margin of $2,000 is now $1,000, which is $2,000 minus $1,000 in losses. The exchange makes the trader sell their crypto because their remaining equity ($1,000) has dropped to the maintenance margin ($1,000).
- The position closes on its own, and the trader loses the whole $2,000 margin, but not the money they borrowed. If the asset price goes up, the same thing happens for short liquidation.
What Causes Liquidation in Crypto?
The main reason for liquidation in crypto is a big drop in the price of the underlying asset that lowers the trader’s equity or margin below the level needed to keep the position open. This is the most important reason why the exchange will automatically close the position.
The crypto markets are very unstable. A sudden, sharp, and unexpected price change, also known as a “flash crash” or “rapid reversal,” can quickly wipe out a trader’s margin, which starts the liquidation protocol.
This volatility makes margin trading even riskier. Using a lot of leverage makes the distance between the entry price and the liquidation price much shorter.
Leverage makes profits bigger, but it also makes the risk of losing everything much higher. If you don’t add more collateral (margin) to the position when a margin call is made, it will also directly lead to liquidation.
A margin call is a warning from the exchange that your margin is very low. If you ignore this warning or don’t act quickly, it shows that you don’t manage your risks well and the system will automatically close your account.
Lastly, if the underlying asset doesn’t trade or have a lot of liquidity, the exchange might not be able to close the position at the exact liquidation price. In times of high volatility or low liquidity, the fill price, or the price at which the position is actually closed, may be worse than the bankruptcy price.
Slippage is what this is called, and it can sometimes cause a loss that is technically more than the trader’s collateral balance (a negative balance). Most major exchanges, on the other hand, have complex insurance funds that protect traders from losing more money than they put in.
What Is the Liquidation Process of Cryptocurrency?
The process of selling cryptocurrency is quick and done automatically. It is meant to keep the exchange and the market as a whole liquid:
- Margin Call: When the position goes against the trader, their margin level goes down. A lot of exchanges will send a margin call to the trader, telling them to put up more collateral.
- Trigger Point Reached: If the trader doesn’t add collateral and the margin falls to the maintenance margin level, liquidation happens.
- Automatic Closure: To stop further losses, the exchange’s system automatically closes the leveraged position at the current market price (or an internal price). The trader’s initial margin is the loss.
- Use of the Insurance Fund: The exchange’s insurance fund makes up for any losses that happen when the liquidation price is lower than expected in volatile markets.
Is Liquidation Good or Bad for Crypto?
It is hard to say if liquidation is “good” or “bad” because it depends on the point of view of the person or the market as a whole. For the person doing margin trading, liquidation is definitely bad.
It means that they lose the margin (collateral) they put up for the position right away and completely. This automatic forced closure means that they lose their entire initial investment, but it also means that they can’t go into debt more than the amount they deposited with the exchange.
This painful, automatic loss happens when the required maintenance margin level is not done. Liquidation is necessary from the point of view of the exchange and the market as a whole, so it is “good” for keeping things stable and liquidity.
Liquidation keeps the exchange from having to pay for its traders’ losses. The exchange makes sure it gets back the money it lent out by automatically closing the position before the negative equity hits zero.
The process helps keep the market honest. If there were no automated liquidation, a lot of bankrupt leveraged traders could make the whole platform unstable. When assets are sold off during liquidation, it makes the market more liquid, but sometimes this means that prices drop in the short term.
Who Benefits from Crypto Liquidation?
The trader who is going through liquidation does not benefit, but the process itself does help a number of other parties and market functions. They are the main ones who benefit because liquidation makes sure that the borrowed money used for the leveraged trade is returned.
This step is very important for the platform’s ability to stay in business and keep offering margin trading services. Also, exchanges usually charge a small, set liquidation fee, which helps them make money.
Exchanges keep large insurance funds, which are often paid for by previous liquidation fees, to cover shortfalls when the liquidation can’t happen exactly at the trigger price because of high volatility.
When a trade is liquidated, the exchange can use these funds to fill in the gaps, which helps the system stay solvent as a whole. Events that lead to liquidation can make prices move quickly and in small areas.
Sophisticated arbitrage traders keep an eye on liquidation thresholds and can make money by buying the assets that are being forced to be sold or by taking advantage of sudden price differences that happen when large positions are forced to close.
These traders help the market stay liquid by quickly stepping in. For these groups, the efficiency of the liquidation in the crypto process is often very important.
What Is the Difference Between Long Liquidation and Short Liquidation?
The only difference between long liquidation and short liquidation is the direction the market moves that causes the forced closure.
Long Liquidation
This happens when a trader bets that the price of a digital asset will go up by taking a “long” position. Long liquidation happens when the price of an asset drops a lot, making the value of the position drop below the maintenance margin level. In this case, the trader lost money because the price went against their “buy” bet.
Short Liquidation
This happens when a trader bets that the price of a digital asset will go down by taking a “short” position. If the price of the asset goes up a lot and the position’s value drops below the maintenance margin level, short liquidation happens. The forced closure happens because the price went up against their “sell” bet.
In both cases, the account equity can’t cover the losses that haven’t happened yet, so the platform steps in to stop more debt from building up. To manage risk in margin trading, you need to know this difference in direction.
Key Steps to Minimize the Crypto Liquidation
When you trade on margin, you need to be very careful with your risk management to keep the risk of crypto liquidation as low as possible. Monitoring the size of your position and the amount of collateral you have are the most crucial steps in preventing cryptocurrency liquidation.
- The less leverage you use, the bigger the price change needs to be to reach the liquidation price. The best way to make the distance between your entry price and the forced closure point bigger is to lower your leverage.
- Stop-loss orders are automatic instructions to close your position at a certain price before it reaches the platform’s liquidation price. This is the best way to keep your margin from losing everything.
- Crypto markets are very unstable. Monitor market news and potential events that could trigger a sudden increase or decrease in value.
- You can always see where your money is going by using an app to check your balance. Taking pictures of receipts and setting spending alerts are two simple things that can help you keep better track of your daily expenses.
How to Avoid Crypto Liquidation?
The best way to avoid crypto liquidation completely is to never use leverage at all. There is no margin level to keep when you only trade with the money you have (spot trading), so there is no risk of being forced to close.
But if you want to keep margin trading, there are some useful tips for managing the risk of crypto liquidation. You should always know and be able to quickly calculate your liquidation price for every leveraged position. This way, you won’t be shocked by a sudden loss.
Check your maintenance margin level in real time very carefully. Don’t wait for a call to the margin. You can easily check your security settings and see how much money you have in real time.
Be careful when you trade. Even if you don’t use a lot of leverage, a small price change can still be very bad if your position is too big compared to the rest of your account equity.
Just like people carry cash and cards to lower the chance that they’ll lose everything in one event, you should spread your money out over a few cards or accounts. This breaks up your risk.
Before you leave, check your digital wallet, change your security settings, and make sure your identity verification is up to date. This will make it easier to use in other countries, just like making sure your trading account is safe and working.
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Wrapping Up
Liquidation isn’t just a part of the market; it’s an important lesson on how to manage risk. The crypto market can be very unstable, which can cause unexpected forced closures. It takes more than luck to get through the ups and downs of the digital economy.
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