What is liquidation when trading crypto?

One of the most dangerous and attractive aspects of crypto is the industry’s high volatility. Crypto markets are open 24/7, meaning these volatile swings can happen at any time. While this can be great for traders eager to capitalize on price movement, it can also present challenges, such as trade liquidations.

Liquidation is one of the primary threats to crypto traders who use leveraged positions when margin trading. As such, it's important to understand liquidation and how it can affect an open position. In this guide, we'll explain what liquidation is, why it happens, and what types of liquidation there are.

TL;DR

• Liquidation occurs when a trader is forced to close their position because they lack the funds to meet the margin requirement for their leveraged position. As such, liquidation is a real threat for those who choose margin trading.

• Before a trader's position is liquidated, an exchange may make a margin call. This prompts the trader to deposit more funds to cover their losses and avoid forced liquidation.

• Two types of liquidation are possible. Partial liquidation would see only a portion of a trader's position close, while total liquidation sees a trader sell their entire trading balance to cover losses.

• It's possible to mitigate the risk of liquidation through the responsible use of leverage, adopting a stop-loss, and determining the risk percentage of a trade.

What are crypto liquidations?

Liquidation is a process that can occur when a trader takes a leveraged position. The liquidation process means that traders are forced to close their position. The trader can suffer a partial or total loss of their initial margin. In other words, they can't meet the margin requirements for the leveraged position. They simply have insufficient funds and can't 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 drop in the asset's price.

Why do crypto traders use leverage?

Trading with leverage allows you to potentially maximize your gains even from the smallest price changes. Leveraged trading means that you'd use only a portion of your own funds, with the rest borrowed from the exchange.

Of course, an exchange will only lend you funds when you provide 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 the loss of the borrowed funds, which also means the loss of your collateral. This is why you must take precautions against sudden price changes, which is where risk management comes into play.

If the price changes suddenly and you can't meet the margin requirements, forced liquidation takes place. With leveraged trading, this can happen extremely quickly, before you get the 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. By doing so, you can prevent your position from being closed. 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 this occurs, the exchange makes a margin call, inviting the trader to deposit more money. If the trader chooses not to do this, their account will be liquidated. This happens automatically when the trader’s position reaches the liquidation price.

One important detail to know is that exchanges also charge a liquidation fee. This fee acts as an incentive for traders to either add more funds or close their positions on time. In other words, it's better for everyone if the trader closes the position before it's automatically liquidated.

What is the liquidation price?

It’s also imperative to be aware of your trades' liquidation price. The liquidation price is the point at which your leveraged positions are closed automatically. There are no more negotiations or opportunities, and liquidation happens automatically.

The liquidation price isn't a fixed price but instead depends on a number of factors. These may include the leverage used, the asset's price, the remaining account balance, and the maintenance margin rate.

Types of liquidation

There are two types of liquidation. The main difference between them concerns the extent to which your trading positions are closed, and whether the liquidation is forced or voluntary.

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 type involves selling your entire trading balance to cover losses. Total liquidation is typically forced liquidation, which means you 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's 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, and see an exchange 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.

Determine the risk percentage

The first method of avoiding liquidation involves the risk percentage. This method requires traders to make a decision on the amount of money they’re willing to allocate towards the trade. Additionally, traders must decide on the percentage of their trading account they're willing to risk. This is part of risk reduction. Many agree that traders should only risk 1% to 3% of their account per trade. If a trader risks only 1% of their account, they'd have to lose 100 consecutive trades to lose everything. Even in the crypto industry, this is highly unlikely.

Always use a stop-loss

The second option is to use a stop-loss, which can significantly reduce the amount of money you'd lose if a trade was to move against your position. For example, you could set a stop-loss order at 2% under the entry price. If the market suddenly turns, you'd only experience 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're not paying attention, you can easily miss your chance to exit your position safely. This is why risk mitigation is absolutely crucial for safe trading.

Be cautious with leverage

Although the potential for increased gains from leverage is an exciting prospect, it's important to use the tool wisely. Too much leverage can increase the risk of liquidation and threaten your open positions. Figuring out the correct leverage amount isn't an exact science, and there are a few factors to consider. First, understand your risk tolerance, which should be based on the amount of funds you're willing to (and can afford to) lose. Second, consider the current market volatility. A highly volatile market might not be the best time for high leverage, as major price swings could happen suddenly. Third, trust your trading strategy and follow it diligently. If your strategy demands a long-term position with low leverage, it's unwise to make a sudden and impulsive high-leverage trade in the hope of a quick gain.

The final word

Crypto is inherently volatile, meaning liquidation is a real possibility — especially when trading with leverage. And, because liquidation can result in a loss of funds, traders of all experience levels would be wise to remain alert to the threat even during periods of low volatility.

The liquidation of a trade is usually conducted by the exchanges themselves, which is why the process is commonly referred to as forced liquidation. Once again, this is common whilst trading with leverage, especially when the liquidation risk is quite high.

Thankfully, the risk of liquidation can be reduced, including using a stop-loss order and determining the risk percentage of a trade. Taking the time to understand and implement these risk management processes could save you from larger losses and keep funds in hand for future trades.