12 December 2022 • 8 min read
Cryptocurrencies can be high-risk investments, with some coins exhibiting extreme price swings, and it’s precisely this volatility that can make them especially attractive to certain investors. Crypto trading gives investors the opportunity to make significant profits, especially compared to the more limited profit margins typical of traditional asset classes like stocks or precious metals.
For example, during the COVID-19 outbreak in 2020, Bitcoin ended the year up 160% while the S&P 500 index was up only 14%. And while it provided an excellent opportunity for crypto investors at the time, the market has had plenty of downturns, too. One of the knock-on effects of this high volatility can be what is referred to as liquidations.
But what exactly are liquidations? And how can you avoid being liquidated? Before opening any leveraged positions, you’ll want to ensure that you’ve established a careful trading strategy in order to avoid the prospect of a liquidation. In the following guide, we’ll explore the ins and outs of liquidation in crypto trading, offering a handy primer on what it means and how to avoid it.
Generally speaking, liquidation refers to the ability to turn an asset into cash. In the world of crypto trading, however, it has a slightly different meaning.
When the price of a crypto asset drops, a crypto exchange will sometimes forcibly close a trader’s leveraged position. This happens when a trader has insufficient funds to keep a leveraged trade open. In other words, they’re not able to meet the margin call, which is one of the risks of margin trading.
If the market moves against your leveraged position to a large degree, you may lose your entire collateral (or “initial margin”) and your position could be liquidated. In other words, your initial capital input will be surrendered to the exchange.
The volatility inherent in the crypto market has increased due to the popularity of derivatives. When we talk about derivatives, we’re refering to margin trading, perpetual swaps, and futures. These are different types of contracts based on the price of an underlying crypto asset, and they allow traders to conjecture on where the asset’s price will be in the future.
One thing to keep in mind is that they’re not unique to the crypto market. Traditional stock market traders who buy call or put options and short stocks are using similar strategies. But because of crypto’s widely known volatility, derivatives are a double-edged sword due to the possibility of a liquidation.
Whenever you’re trading with a leveraged position, you’re at risk of liquidation should the market move against you to a certain degree. If you lose a given amount of your position, the exchange will automatically liquidate it so that it doesn’t lose any more money.
Exchanges are permitted to do this because, when you’re trading with leveraged positions, you’re borrowing money from the exchange. Essentially, liquidation serves as an insurance policy of last resort so that the exchange doesn’t lose money on leveraged trades.
There are two main types of liquidation: partial liquidation and total liquidation. In the context of crypto, both of these types are forced liquidations.
A partial liquidation is the most common type of liquidation, and it occurs at an early stage before all of the initial margin is used. Its goal is to prevent loss for the trader. The terms of a partial liquidation depend on the preset agreement between the trader and the exchange, and so it pays to read the fine print.
A total liquidation occurs when all of the initial margin is used and the exchange forcibly closes the entire position in order to prevent any further losses. The trader loses all invested capital and still may have to pay off a negative balance.
A forced liquidation happens when a trader does not or cannot meet the “margin call” for a leveraged position. In other words, they don’t have enough funds to keep the position open. It’s important to note that a forced liquidation usually prompts an additional liquidation fee, which has been put in place to encourage traders to manually close positions before they’re liquidated.
The terms “long” and “short” simply refer to what type of trade an investor is making. Short trades are bets against price rises, and so short liquidations refer to liquidations that happen on these types of trades. Long trades are those that expect price levels to rise, and long liquidations are those that occur on such trades.
Let’s take a step back for a minute and consider a specific type of trading. Crypto liquidation can happen when you’re taking part in margin trading, but what exactly is margin trading?
Margin trading is essentially borrowing money from crypto exchanges in order to increase your trading volume and leverage (the size of your trading positions). With more leverage, you can open a larger position with lower capital, increasing your potential gain. There are several exchanges that offer margin trading to retail investors.
But there’s always a flip side to the coin, namely the fact that margin trading carries more risk of liquidation. Of course, exchanges won’t let you borrow money for them without any collateral. You’ll have to put up what’s called an “initial margin” in order to open a leveraged trading position. Think of the initial margin as an insurance policy for the exchange in case your trade goes sideways.
So while you are borrowing money from the exchange, you’re also putting up some of your own capital. In the case of liquidation, which will occur if the market moves a certain amount against your position, the exchange will forcibly close your position and recoup your initial margin to keep itself from losing any more money on what you borrowed.
Futures contracts are another crypto trading strategy that can lead to liquidation. But that begs the question once again: what are crypto futures exactly?
A futures contract involves a buyer agreeing to purchase and a seller agreeing to sell an underlying asset at a fixed price at a future date. Just like margin trading, this derivatives product is not unique to the crypto industry; it works similarly to options trading on the traditional stock market.
A bearish trader will buy through a futures contract, hoping that the price of the asset will rise. If it does, the bearish trader has locked in the right to purchase the asset at a discounted price, and can then sell it at market price, resulting in a profit.
A bullish trader will sell through a futures contract, hoping that the price of the asset will fall. If it does, the bullish trader has locked in the right to sell the asset above market price. They can buy the asset at market price immediately before selling it above that price to turn a profit.
While many traders rue the day that they’ve had to face the prospect (or worse) of liquidation, it can actually save you from detrimental losses. (Of course, there are many strategies to keep you from getting to that point in the first place.)
Similar to margin trading, futures trading can lead to liquidation if a trader cannot meet margin requirements. In other words, the trader doesn’t have enough funds to keep the trade open. When your leveraged position hits the liquidation thresholds, you’ll face a “margin call.” If you cannot put up more margin, then your position will be liquidated.
The liquidation process has been put in place to keep exchanges from losing the money you borrow from them when taking on leveraged positions. Let’s say that you’ve taken out a leveraged position of, say, 50X. An exchange doesn’t necessarily expect traders to be able to pay the full amount of this type of position, which is why liquidation can and does occur before the full borrowed amount has been lost.
Now that you’re aware of the bad, let’s focus on the good, namely, how to avoid a liquidation.
When you’re trading with leveraged positions, you have several strategies in your toolbox that can help to mitigate your chances of being liquidated. Among the most popular and most effective is something referred to as a stop-loss order. Effectively, the exchange can close your position at a predetermined time, thereby saving you from bigger losses in the event that a liquidation becomes necessary. Think of a stop-loss as an emergency break; if things turn too far against your position, then you have an in-built fail-safe to prevent additional losses.
Also known as a “stop loss” or a “stop-market order,” a stop order is an order that you can place through a crypto exchange, telling the exchange to sell an asset when its price hits a certain point. As such, it’s an essential piece of risk management for leveraged trading.
You’ll need to know your stop price (the price at which the order will go into effect), the sell price (the price at which you’d be willing to sell the asset), and the size (how much of the asset you want to sell). If the asset hits the stop price, the exchange will automatically execute your order and sell the amount stated at the price stated.
As you’ll have inferred by now, stop losses are designed to limit your potential losses. There’s no proven rule for where to set a stop loss, but it’s generally recommended to set it between 2% and 5% of your trade size. Additionally, you’ll want to keep your per-trade losses below 1.5% of your entire account size.
If you’re not interested in placing a stop order, you can also keep track of your losses manually using the following formula. In this case, you’ll want to know the percentage the market needs to move against your position for it to be liquidated.
Liquidation % = 100 / Leverage
We’ll break it down using a real-life trading example. Let’s say that you’re opening a position with an initial margin of $100 and leverage of 4X in order to create a position of $400. Using our formula, it looks like the following:
25% = 100 / 4
As you can see, you’ll face liquidation if the price of the asset moves 25% against your position. In other words, liquidation would occur in this scenario if your $400 position moves down to a value of $300.
While you can keep track of this manually to ensure that you exit before that happens, stop orders can be a much more efficient and safer way to monitor your positions and mitigate risk.
Leveraged positions can cut both ways. With the bad comes the good (and vice versa).
Higher leverage will lead to larger profits when a trade goes well, which is one of the reasons why margin trading has proven to be an especially popular form of trading, particularly during the ongoing crypto bear market. Nevertheless, because of the leverage (or based on the extent to which one is leveraged), only a small negative price movement can be required in order to trigger a liquidation.
When you’re trading with leveraged positions, it’s good practice to use proven strategies such as stop orders to mitigate your potential losses (and protect your gains). More importantly, it’s vital to understand the actual mechanics as well as the strengths and weaknesses of any given trading strategy. And since margin trading can be challenging, knowing exactly what a liquidation is and how to avoid one will ensure long-term trading success without the headaches of short-term losses.