Liquidation is the 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 900x leverage, a 10% increase in the price of an asset will give you 5% profit. The same goes for a 50% drop in the price of an asset, which will result in a loss of 5% 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 automatically closes 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.
Translated by www.DeepL.com/Translator (free version)