What is the liquidation of cryptocurrencies and what to do?

Cryptocurrencies are known for their volatility. This makes them prime targets for elimination. LiquidationA liquidation is a sale of cryptocurrencies, usually forced, as a result of an investor's inability to secure a minimum margin for their leveraged position. Notorious for their volatility in the market, cryptocurrencies can quickly and easily lead to liquidation, especially when investors lose their leveraged positions and their investment plunges into negative balance, requiring them to sell crypto assets when a position is forced out. This usually happens in cryptocurrency margin trading, when investors borrow money from a crypto exchange or broker to increase their funds or assets for trading. While leveraged trading positions can lead to higher potential profits, this is a very risky move that could lead to liquidation if the price of the asset drops sharply and you lose your initial margin or equity. If you do not have enough funds to continue trading and cannot meet the minimum margin requirements for your leveraged position, the exchange may automatically close your position, resulting in a permanent loss of funds from your initial margin. This liquidation loss can be partial or total, depending on the initial margin and the extent of the price drop. A partial liquidation occurs when a position is partially closed at an early stage in order to reduce the position and the investor's leverage, while a full liquidation occurs when almost all of the initial margin has decreased due to a price drop. To better illustrate the liquidation process in cryptocurrency margin trading, here is an example: Suppose you start with an initial margin of $100 and 10x leverage. This means that your total trading position is $1, of which $000 is borrowed from an exchange or broker. The amount of leverage corresponds to the size of your profit or loss from the position. With 10x leverage, a 5% increase in the price of an asset will give you 50% profit. The same goes for a 5% drop in the price of an asset, which will result in a loss of 50% of your initial margin. The formula for calculating profit or loss is as follows: Initial Margin × (% Price Change × Leverage) = Profit/Loss. Based on the above calculation, a 10% decrease in the price of an asset will result in a loss of 100% of your initial margin. Before you lose all of your initial margin, you can get a margin call when the liquidation threshold is reached so you can decide if you want to add more equity to your margin to keep your position open (or lose your initial margin entirely when the exchange or the broker will automatically liquidate your position). When you force-close a position, the exchange or broker may charge you a liquidation fee, but you can avoid this fee if you close the position before it is liquidated. Liquidations often occur when investors are tempted by higher leverage, which can potentially bring them greater profits, but do not consider the possibility of incurring large losses, which can also lead to liquidation. Therefore, it is very important to apply smart crypto trading strategies in order to avoid liquidations, whether starting with lower leverage or carefully monitoring margins and liquidation prices. Using a stop loss order is another way to limit your losses as the order will automatically close the position for investors when it hits the stop price to prevent further losses. Investors may also consider using exchange insurance funds to protect themselves from excessive losses. — the protagonist of cryptocurrency trading — occurs when an investor fails to meet the margin call for their leveraged position. Traders increase the funds they can trade with by borrowing from a third party — in this case, an exchange.

Although using leverage or borrowed funds to increase trading positions can multiply the potential profit many times over, this is a very risky move. You could lose your initial margin or equity if the market goes against your leveraged position.

In this article, we will take a detailed look at what cryptocurrency liquidation is, how to avoid it, and what to do if it occurs. We will also look at why volatile trading environments are more prone to liquidation. Let's start!

What is Cryptocurrency Liquidation?

Liquidation is the process of selling crypto assets for cash in order to minimize losses, especially in the event of a market crash.

However, in the crypto space, the term liquidation is mostly used to describe the forced closure of a trader’s position due to a partial or complete loss of their initial margin. This occurs when a trader fails to meet the margin requirements for their leveraged position — meaning they don’t have enough funds to keep the trade open. Margin requirements are often missed when there is a sudden drop in the price of the underlying asset.

When this happens, the exchange automatically closes the position, causing the investor to lose funds. The degree of loss depends on the size of the initial margin and on how much the price has fallen. In some cases, this can lead to a complete loss of investment.

Liquidation can be divided into partial and complete. For example:

Partial liquidation: A liquidation in which a position is partially closed early to reduce the position and the leverage used by the trader.

Complete liquidation: Closing a position with almost all of the trader's initial margin.

Liquidation can occur in both futures trading and spot. However, traders should be aware that when buying a contract, the price is based on the asset and not on the asset itself. This results in fluctuating profits and losses when they are converted back into the price of the current asset.

What is cryptocurrency margin trading?

Margin trading of cryptocurrencies is the process of borrowing money from a crypto exchange to trade a larger volume of assets. This can provide a trader with increased purchasing power (or “leverage”) and the potential for greater profits. In other words, leverage means borrowing funds to enter into a larger position than your own funds allow. However, it also carries greater risk, as leveraged positions can be liquidated quickly if the market moves against you.

To open a trading position in margin trading, the exchange will require you to deposit a certain amount of crypto or fiat currency (also known as the “initial margin”) as collateral. These funds help insure the lender against losses if the trade falls through. The maintenance margin is the minimum margin required to keep the position open.

Leverage is calculated by using the amount of funds you can borrow from the exchange in relation to your initial margin. Let's consider a simple example. If you start with $1 initial margin and 000x leverage, that means you borrowed $10 to increase your trading position from $9 to $000.

The degree of leverage also determines the potential to make or lose money. Using the example of 10x leverage, if the price of your asset rises by 5%, you will make a profit of $500 (or 5% of $10) on your trading position. That is, with a price increase of only 000%, you made a profit of 5% of your initial margin of $50. Sounds profitable, right?

But cryptocurrencies are notoriously volatile and the price of your asset can drop in an instant. So, continuing with the above example, if the price of an asset falls by 5%, you will lose $500, or 50% of your initial margin, which means a loss of 50%.

The goal of trading is to make a profit. The formula for calculating how much you can make or lose using leverage is simple:

Initial Margin × (% Price Movement × Leverage) = Profit or Loss.

One important note about margin trading cryptocurrencies: When positions are liquidated, they are always closed at the current market price. Your losses are magnified by the size of your leveraged position. In other words, if a trader loses $1 of a $000 open position, they lose all of their initial margin. Therefore, it is very important to be aware of all the risks before borrowing money to trade cryptocurrencies.

How is the liquidation of cryptocurrencies?

Liquidation occurs when an exchange or brokerage firm closes a trader's position because it can no longer meet its margin requirements. Margin is a percentage of the total value of a trade that must be deposited into the broker's account to open and maintain a position.

When a trader's margin account falls below the level previously agreed upon with the exchange, positions automatically begin to be liquidated. When your leveraged position reaches the liquidation threshold, you will face a "margin call," which means that additional margin must be posted. Liquidations tend to occur more frequently on futures contracts, where traders use higher amounts of leverage.

At this point, there are two options: Either you can add funds to your margin to bring back leverage above the required level, or the broker will automatically liquidate your position.

Continuing with our $1 initial margin example, let's say you entered the trade with 000x leverage, meaning your leveraged position is now $10 - that is, $10 of your own money and the $000 you borrowed from the exchange.

Let's say your BTC goes down 10%. Your position is now worth $9. If the decline continues and the losses on your position increase, they will be attributed to borrowed capital. To avoid losing borrowed capital, the exchange liquidates your position to protect the money you borrowed. Your position is closed - and with it, your initial capital of $000.

That's not all. Exchanges generally charge you a liquidation fee. The idea is to encourage traders to close their positions before they are automatically liquidated.

It is important to know that leverage works both ways: Higher leverage will make you more money if the trade is going well, but a small negative price movement is enough to induce liquidation. For example, a trading position with 50x leverage would only require a price cut of 2% to initiate a liquidation.

However, there are other cases where exchanges offer maintenance margins that are set at 0,5% of the bankruptcy price rather than the entry price. This also means that the trader's position will not be partially liquidated, but will only be liquidated if 0,5% of the initial margin is left. However, if you must use leverage, you may want to limit yourself to the amount you can manage.

Explanation of liquidation price

The liquidation price is the point at which your leveraged positions are automatically closed. This threshold is influenced by several factors: the leverage used, the maintenance margin rate, the price of the cryptocurrency, and the balance in the account. Exchanges calculate the liquidation price for you, which may be an average taken from several large exchanges.

When the price of your cryptocurrency crosses the liquidation price threshold, the liquidation process begins. Cryptocurrency prices are constantly changing, so it is important to follow the latest news and make sure that your positions are still profitable. Otherwise, you may end up being automatically liquidated at a loss.

Bitcoin Liquidation Examples

A trader may need to liquidate their bitcoin to cover a short position or to meet other financial obligations. When this happens, the trader will usually sell their bitcoin at the current market price, regardless of whether it is above or below the original purchase price. However, in some cases, a trader may be forced to sell their Bitcoin at a price below the market price. This may turn out to be the liquidation price, and it is usually determined by the exchange where bitcoin is traded.

In early January, when Bitcoin fell below 43K, more than $812 million in cryptocurrency futures were liquidated, resulting in large losses for traders trading long cryptocurrencies. This happened due to partial or complete loss of initial margin by traders.

It is important to note that the liquidation price may change at any time, depending on current market conditions. Therefore, if you are thinking about selling your bitcoin, it is always worth checking the latest liquidation price before making a final decision. This will ensure that you are getting the best possible deal.

Forced Liquidation vs Liquidation: Differences

The term “liquidation” simply means converting assets into cash. Forced liquidation in crypto trading means forced conversion of crypto assets into cash or cash equivalents (e.g. stablecoins). Forced liquidation occurs when a trader fails to meet the margin requirement set for a leveraged position. When this condition is met, the exchange automatically sells the trader’s assets to cover their positions.

The main difference between liquidation and forced liquidation is that in forced liquidation

trader's positions are closed automatically by a third party (for example, an exchange), while

ordinary or voluntary liquidation, the trader must close them himself. A trader may decide to cash out a cryptocurrency trade for various reasons.

Another key difference is that in a forced liquidation, all positions are closed at the same time, while in a voluntary liquidation, they can be closed gradually.

Forced liquidation protects traders from additional losses. However, this can also be a disadvantage, as all positions are closed at the same time, which can lead to missed opportunities. Regular liquidation, on the other hand, gives traders more control over their positions as they can close them out gradually. However, this also means that they are more prone to losses if the market moves against them.

How to Avoid Liquidation of Cryptocurrencies

While there is always a chance of losing money on a trade, using prudent trading strategies such as using less leverage and controlling margin can help a trader avoid liquidation. Crypto exchanges also offer insurance funds as a way to minimize trading losses.

Insurance funds

The insurance fund is a reserve pool of funds that acts as a safeguard against excessive losses. It is used to cover losses on a contract. Thus, when a trader's position is liquidated at a price better than the bankruptcy price (i.e., at a price at which the trader's loss equals his initial margin), any gain goes into the insurance fund.

On the other hand, if the liquidation price is less than the bankruptcy price, the loss on the position will exceed the trader's initial margin. Then the insurance fund will cover this deficit (or negative capital).

For example, John and Alice opened different long positions in BTC with a bankruptcy price of $40 and $000, respectively. They both have a liquidation price of $39, so when they liquidate, John liquidates at $500, taking away his insurance fund, and Alice liquidates at $40,200 with the addition of an insurance fund based on the last traded price of $40,000.

Liquidation Deal Exit Strategy

Insurance funds are safety nets that protect failed traders from adverse losses. However, using a liquidation exit strategy can prevent this risk in the first place. The goal of an exit plan is to minimize the amount of money lost.

Examples of liquidation exit strategies include using limit, trailing stop loss, or stop loss orders to close out positions before liquidation occurs.

Stop Loss: Using a stop loss order means that the trader decides to close the position with a market order as soon as the last traded price reaches the predetermined price. Stop loss orders act as a safety net to limit potential loss that crosses the entry price.

Trailing Stop Loss: This means placing a stop loss order following the last traded price at a predetermined distance and direction. Thus, when the last traded price peaks and moves in only one direction, the trailing stop is triggered. This way you limit losses and increase unrealized profits when the market price moves in your favor.

Reducing leverage, even slowly, is also one way to deal with liquidations. However, the first step is to keep track of liquidation prices and how close your positions are to being unable to cover margin.

Сonclusion

Before you start trading cryptocurrencies, make sure you understand what liquidation is and how to avoid it. Liquidation of cryptocurrencies occurs when an investor fails to meet the margin requirement for their leveraged position. Traders increase the funds they can trade with by borrowing from the exchange.

While using leverage or leverage to increase your trading positions can multiply your potential profit many times over, it is a very risky move that can also increase your losses. However, you can avoid liquidation if you keep an eye on your margin, use leverage wisely, and use trading tools such as stop loss and limit orders.