As most crypto participants understand, the crypto market’s high volatility is not going anywhere any time soon. Thus anyone hoping to trade the market needs to make peace with it and trade positions accordingly.
When you open a trading position for either a margin or leveraged Futures trade on a crypto exchange, you are using borrowed funds to hopefully generate significant profits.
You lost all of it, didn’t you?
This article will take you through how liquidation happens in the crypto world and how you can save yourself from it.
What Is Crypto Liquidation?
Liquidation occurs in the crypto world, just like it does in the traditional asset classes, and is the forced closing of all or part of your initial margin position.
This is done either by the trader on the other side of your trade or the entity that lent you the assets.
A forced liquidation happens when you do not meet the requirements of a leveraged position to keep the trade open.
You have a leveraged position if you have used the assets in your wallet as collateral for borrowing third-party funds as a loan.
This collateral and the borrowed money are then used to enter a leverage trading position for a particular asset at a particular price point. The aim is obviously to make a profit so that you can return the third-party funds and keep the initial margin and profits.
Most decentralized lending protocols, including Aave, and MakerDAO, have a liquidation function, so it is not correct to think only centralized exchanges manage liquidations aggressively.
So when the market price of a crypto asset has extreme price swings, a trader’s leveraged position can undergo forced liquidation, which means a partial or total loss of initial capital used to open the trading position.
You must remember that the higher your leverage, the more difficult it is for your leveraged position to avoid liquidation.
Once you are liquidated, the third party that lent you the money can buy the liquidated assets at a discount and then sell them in the open market to earn the difference, or they can hold on to the asset if they foresee positive price movements for it.
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What Is The Liquidation Price In Crypto?
A higher leverage position makes you more susceptible to liquidation, and you can lose your invested capital (initial margin) if the market price of the asset reaches the liquidation price.
Countries like the United Kingdom have banned leading centralized crypto exchanges from offering leveraged trading products to protect novice traders from complete or partial liquidation of all their invested capital.
A responsible trader will calculate their liquidation price before entering their trading positions, and you can be one of them too. Just use this simple formula.
Liquidation % = 100/Leverage
So, if you take a long leveraged position on Bitcoin with 25x leverage, your position stands to be liquidated if Bitcoin’s price falls by 4% (100/25) relative to your initial position if you do not have sufficient funds to keep the trade open.
When the price reaches this price, the crypto exchange automatically closes the position resulting in the loss of crypto or fiat currency depending on what was used as collateral.
Liquidations are generally categorized into partial or total liquidation.
Partial liquidation refers to when your crypto trading positions are closed partially early on to reduce the position size and leverage used by a trader.
Total liquidation is when your trading position is fully closed, as all of the initial margin of the trader has been used, and there are no more funds to keep your position open according to the margin requirements for your position.
How Does Crypto Liquidation Happen?
Crypto liquidation happens when an exchange (central or decentralized) closes out a margin trading position as it does not meet margin requirements anymore.
The margin is the percentage of the total trade value that the exchange keeps with itself to open and maintain a trading position.
You will know what your liquidation price is when you are placing your trade. So when the trader’s margin account falls below this price due to negative price movements, the algorithm will start liquidating your positions.
To prevent this, you get what is called a ‘margin call’ that requires you to increase the margin balance in your account.
At this point, you can either add funds to your margin trading crypto exchange account to bring the leverage back above the requirement or get liquidated and lose your initial margin.
Most of the liquidations happen where Futures contracts are involved, as retail investors and other sophisticated traders use higher amounts of leverage when taking these positions.
For example, you enter a long trade on Bitcoin with an initial margin of $100 with 20x leverage. This means that your position in the market is now worth $2,000, $100 coming from your pocket, and the other $1,900 lent to you by the exchange or a third party.
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If the asset’s price rises by 10%, your position is now worth $2,100. If you are happy with the gains, you can close your position, get back your initial margin of $100, the profit of $100, and return the $1,900 in funds you got from the exchange.
This was the rosy scenario.
The problem happens when the price moves against your preferred direction. If the price of your crypto assets like Bitcoin slipped by 10%, the new value of your position is $9,000.
At this point, you have lost the money you put in, and any further dip will eat into the funds received from the exchange.
When the market price reaches the liquidation price, the exchange will close the position, effectively liquidating you and protecting the money lent to you.
Most exchanges also charge a liquidation fee to encourage voluntary liquidation before the algorithm does it for you.
Something to understand from these examples is that high leverage is a good thing till it’s in your favour but can be your worst enemy if it goes against you.
For example, if you take a 100x leveraged trade, it only takes a 1% price movement to initiate a liquidation event.
Crypto Exchanges like Bybit try to protect their traders from partial liquidation by introducing a maintenance margin of 0.5% that is fixed relative to your initial bankruptcy price instead of the entry price.
In this case, you will not be partially liquidated and will only be liquidated if the margin trading account has 0.5% left.
Why Do Crypto Liquidations Happen?
Because you are borrowing money from an exchange or third party, the lender will need a mechanism to safeguard their money. This is where the liquidation mechanism comes in.
But liquidation is not only limited to centralized exchanges for trading crypto futures but has become a mainstay in Decentralized Finance platforms as well. Let’s take MakerDAO as an example.
You can stake multiple currencies on the platform, including ETH and stablecoins like USDC and TUSD, to diversify both your and the platform’s risk. This also has the effect of working to adjust the supply and demand of DAI, the platform’s cryptocurrency.
This form of lending is known as stake lending, and in this, you will pledge your assets to the protocol in exchange for getting the asset you are looking to get. Once the staking period is done, the assets can be re-staked to earn more income.
So that the system’s stability is maintained, the protocol has a liquidation system in place to reduce its own risk. Don’t worry; you won’t lose all your staked assets, but it will be a fair amount.
The stake rate at MakerDAO is 150%, and this is determined by each protocol for themselves. Once decided, this rate determines the trigger for liquidation.
Let’s try to understand this with an example:
Currently, the price of $ETH is around $1,200, and you stake 100 $ETH to MakerDAO to make a total value of $120,000. This enables you to borrow $80,000 DAI at the platform’s stake rate of 150%.
If the price of $ETH falls below $1,200, your staked position will be vulnerable to liquidation by the platform’s mechanism. If you do get liquidated, it means that you will be buying back your 100 $ETH for $80,000.
Some ways to prevent yourself from this are to either borrow less than the $80,000 $DAI you are allowed to or return some of the lent $DAI before liquidation is triggered.
Or you can just continue to keep staking more $ETH before liquidation occurs, hence reducing the stake rate.
On top of this loss, the liquidation will need you to pay a 13% penalty for getting liquidated. So, you will only receive 87% of your assets. Out of the 13%, 3% goes to the liquidator and 10% to the platform.
The penalty rule is designed so that you keep an eye on your assets and avoid liquidation, hence penalties.
How to Avoid Crypto Liquidation?
There is always a chance that you lose money on trade, as no trader can predict the exact movements of the market. But to be able to limit your losses and avoid liquidation, there are certain trading strategies that you can employ.
Traders that are good at what they do and make consistently profitable trades understand that it is required to plan your entry and exit while indulging in crypto margin trading.
The purpose of an exit plan is to both minimize the loss in a trade and to take profits when the price reaches your target.
Some frequently used exit strategies include limit, trailing stop loss, or stop loss orders to close a position before it gets liquidated.
A stop-loss order means that the position will get closed once the market price reaches the selling price mentioned in the order. These orders act as a safety net and limit the complete loss of a position.
A trailing stop-loss follows the market price and keeps moving the stop-loss according to it. You will decide where you want to keep the trailing stop-loss as it moves in the distance and direction that has been provided.
When the last traded price peaks and only moves upwards, a trailing stop order will get triggered, and when the price starts to drop back down, it will limit your potential losses and increase the unrealized gains when the price moves in your favour.
Another way to stay safe from liquidation is to reduce the leverage on your position slowly. For this, you will need to track the liquidation prices and how close you are to losing your initial margin.
So, before you take the leap into applying your margin or futures trading model with your hard-earned money, take some time to understand liquidation. Also, understand how it happens and how you can save yourself from it.
Retail investors who use high leverage tend to get liquidated left, right and centre when the market moves. At this point, exchanges like Binance Futures have started to limit traders from trading with a cool-off period after large losses.
These exchanges have also reduced the maximum leverage allowed so as to not incentivize high-leverage trading.
Borrowing money from the exchange can be a double-edged sword, so it is recommended to use it wisely.