Liquidation is one of the major threats to crypto traders who use leveraged positions when trading. As such, it's critical to understand liquidation and how it can affect an open position. In this article, we'll explain what liquidation is and why it happens.
What are crypto liquidations?
Liquidation is a process that can occur when a trader takes a leverage position. The liquidation process means that traders are forced to close their positions. 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 going.
In a situation like this, the exchange automatically closes the trader’s position. Unfortunately, this causes traders to lose funds. 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 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 and risk alerts. A margin call is a demand from the exchange for you to deposit extra funds. Normally, a user will receive E-mails or in-app messages from Toobit when the margin ratio of his or her position reaches above 70%. In extreme market conditions, the figure might vary accordingly. By adjusting your position or adding margins, you can prevent your position from being closed. However, if you ignore the margin ratio alert, or you don’t have additional funds to add, the trade will be liquidated.
How do 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 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, requiring 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 is that some 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 if the trader closes the position before it's automatically liquidated.
About 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 fixed but instead depends on several factors. These may include the leverage used, the asset's price, the remaining account balance, and the maintenance margin rate.
In the follow-up series, we will discuss how to do risk management and effectively prevent liquidation with leveraged trading.
Conclusions
-
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 or a margin ratio alert. This prompts the trader to deposit more funds to cover their losses and avoid forced liquidation.
-
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.
