Crypto Liquidation Explained
Liquidations are a common occurrence in a highly volatile crypto market. Since the arrival of crypto derivatives in 2011, it has gathered more momentum in the last decade especially with traders looking to maximize their investment with leverage.
What is Liquidation?
In relation to cryptocurrency markets, liquidation refers to when an exchange forcefully closes a trader’s leveraged position due to a partial or total loss of the trader’s initial margin. It occurs when a trader is unable to meet the margin requirements for a leveraged position (fails to have sufficient funds to keep the trade open.) Liquidation happens in both margin and futures trading.
Trading with a leveraged position is a high-risk strategy, and it is possible to lose a trader’s entire collateral (initial margin) if the market makes a large enough move against his leveraged position.
The trader can keep track of the percentage the market needs to move against his position for it to be liquidated by using this formula:
Liquidation % = 100 / Leverage
For instance, if he uses 5x leverage, his position will be liquidated if the price of an asset moves 20% against his position (100/5 = 20).
How to avoid liquidation?
When using leverage, there are few options available to mitigate the chances of being liquidated. One of these options is known as a “stop loss.”
A stop-loss, also called a "stop order" or "stop market order," is an advanced order that a trader places on a crypto exchange, instructing the exchange to sell an asset when it reaches a particular price point.
When setting up a stop loss, a trader will need to input:
Stop price: The price at which the stop loss order will execute
Sell price: The price at which you plan to sell a particular crypto asset
Size: How much of a particular asset you plan to sell
If the market price reaches a trade’s stop price, the stop order automatically executes and sells the asset at whichever price and amount is stated.
If traders feel the market could move quickly against them, they might choose to set the sell price lower than the stop price so it’s more likely to get filled (bought by another trader).
The primary purpose of a stop loss is to limit potential losses. To put things in perspective, let’s consider two scenarios.
Scenario 1: A trader has ₹5,000 in his account but decides to use an initial margin of ₹100 and leverage of 10x to create a position of ₹1,000. He places a stop loss at 2.5% from his entry position. In this instance, the trader could potentially lose ₹25 in this trade, which is a mere 0.5% of his entire account size.
If the trader does not use a stop loss, his position will be liquidated if there is a 10% drop in the price of the asset. Remember the liquidation formula above.
Scenario 2: Another trader has ₹5,000 in his trading account but uses an initial margin of ₹2,500 and a 3x leverage to create a position of ₹7,500. By placing a stop loss at 2.5% away from his entry position, the trader could lose ₹187.5 in this trade, a 3.75% loss from their account.
The lesson here is that while using high leverage is typically considered very risky, this factor becomes very significant if the trader’s position size is too large. This is large. This is seen in the second scenario. As a rule of thumb, the trader should try to keep his losses per trade at less than 1.5% of his entire account size.
Conclusion:
When it comes to margin trading, risk management is arguably the most important lesson to be managed.
A trader's primary goal should be to keep losses at a minimum level even before thinking about profits. No trading model is flawless. Therefore, the trader must deploy tools to survive when the market doesn’t go as expected.
Placing stop losses correctly is critically important, and while there is no golden rule for setting a stop loss, a spread of 2%-5% of trade size is often recommended.
Alternatively, some traders prefer to set stop losses just below the most recent swing low.
A trader should manage his trading size and the associated risk. The higher his leverage, the higher his chances of being liquidated. Using excessive leverage is akin to exposing his capital to unnecessary risk.
There are some exchanges that manage liquidations aggressively. These exchanges only allow traders to hold BTC as initial margin. If in the future, Bitcoin’s price falls, so too does the amount of funds held in collateral resulting in faster liquidations.
Due to the risk associated with leverage trading, the exchanges have moved to lower the limit that traders can access.
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