Liquidation is an important concept related not only to debt and assets, but also to the cryptocurrency market. Liquidation, also known as liquidation in crypto, means “the forced closing of a trading position.”
What does liquidation mean in crypto?
Liquidation in crypto is the forced closing of a trading position. This usually happens because the margin to close a position is exhausted, ie the trade must be closed, and is a function of leverage.
The act of borrowing money from a cryptocurrency exchange in order to trade large amounts of crypto is known as margin trading. This can give the investor more purchasing power and higher returns.
In other words, leverage is the use of borrowed funds to create a more significant position than the individual’s funds allow. However, it also involves greater risk for such investors as leveraged holdings can be quickly liquidated if the market turns against them.
But of course margin trading is not free money. In order to create a leveraged trading position, the stock market requires the trader to put up money (fiat or crypto) as collateral, often referred to as “initial margin”.
The purpose of this advance capital is to protect the borrower in the event of extreme price fluctuations. The maximum value inverse of the position’s delta is called the liquidation value. If the market trades at this price, the position is liquidated.
Since there is little regulation in the cryptocurrency markets and third parties do not always have the authority to enforce the rules, crypto exchanges prefer to perform mandatory liquidation functions instead of margin calls, so in the traditional market the broker “calls” the investor. and demands more collateral to close the position.
When does liquidation happen?
As mentioned, when the investor is unable to meet the margin requirements for his leveraged assets, he is forced to liquidate the positions.
This usually occurs at the maximum “pain points” of the market, especially when trades are crowded. More specifically, this is likely to occur at highs and lows, support and resistance areas defined by market structure, as well as psychological round numbers and large handles.
More technically, liquidation occurs when the trader’s margin account falls below a percentage of the total transaction value agreed in advance with the exchange.
With 10x leverage on a $10,000 position, you only need 10 percent to break even. To make matters worse, exchanges often include fees for liquidated transactions.
How to stop liquidation?
When traders use stop loss orders to exit positions, they are essentially applying the discipline of saying “this is the maximum loss I can tolerate on this trade”. When used in conjunction with the right risk management techniques, exiting trades that prove invalid is a good practice that can save you and your capital and allow you to trade another day.
Placing a stop loss far enough away from where your liquidation price is will greatly reduce your chances of liquidation. However, as soon as stop losses are triggered as market orders, they are subject to slippage; Which means, theoretically, in an extreme scenario the price could exceed your stop loss level, potentially leading to a liquidation.
Another option is to do small business. By definition, trading a smaller position size reduces your risk and therefore reduces your chances of liquidation.
Leverage and position size go hand in hand, so trading smaller means you’ll need less leverage, which is another way to reduce your risk of liquidation.
Keep an eye on futures open interest on the exchange you’re trading on, as historically high open positions can sometimes be a sign that the market is overleveraged. In the event of market stress, these positions can be liquidated and create a cascade that can even lead to a sudden crash, as has been abundantly seen in the short history of crypto.