Cryptocurrencies are notoriously volatile. This makes them easy prey for liquidation. Liquidation, the crypto trading boogeyman, occurs when an investor cannot match the margin requirement for their leveraged position. Borrowing from a third party—an exchange—increases traders' trading funds.
Leveraging or borrowing funds to boost trade positions is risky but can multiply potential returns. If the market goes against you, you could lose your initial margin or funds.
Crypto liquidation, how to avoid it, and what to do when it happens are covered in this article. We'll also examine why liquidation is more likely in volatile trading settings. Let's find out in this article!
What Is Crypto Liquidation?
Crypto liquidation refers to the process of selling off one's cryptocurrency holdings in order to convert them into a fiat currency or another cryptocurrency. This is typically done in order to realize profits, cover losses, or meet liquidity needs. In the context of margin trading, liquidation may also refer to the automatic selling of a trader's crypto assets by an exchange in order to repay a loan and avoid further losses in a highly leveraged or risky position.
In crypto, liquidation refers to the forced closing of a trader's position due to the loss of their initial margin. When they don't have enough money to maintain their leveraged position open, this happens. When asset prices collapse suddenly, margin obligations are often inadequate.
The exchange will automatically close the position, costing the investor money. The margin and price reduction determine the degree of this loss. It can cause total investment loss.
Partial and entire liquidations exist. Ex:
Partial liquidation: Early liquidation lowers a trader's position and leverage.
Total liquidation: Closing a position uses most of a trader's margin.
Futures and spot trading can liquidate. When buying a contract, traders should know that the price is based on the asset, not the asset itself. That affects profit and loss when converted to the current asset price.
What Is Crypto Margin Trading?
Crypto margin trading is a type of trading that allows traders to borrow funds from a broker or exchange in order to increase their investment potential. In other words, traders can place larger trades with more funds than they would be able to on their own. This allows them to potentially profit more but also increases the risk of larger losses if the trade goes against them. The borrowed funds, or "margin", must be repaid to the lender along with any interest charged. Margin trading is considered a higher-risk, advanced trading strategy and is not suitable for all investors.
The exchange requires an "initial margin" of crypto or fiat currency to begin a margin trading position. These funds protect the lender if the trade fails. The maintenance margin is the minimum required to maintain a position.
Leverage is the ratio of exchange borrowings to starting margin. Simple example. With a $1,000 margin and 10x leverage, you borrowed $9,000 to expand your trading position from $1,000 to $10,000.
Leverage affects trade profitability. If your asset's price raises 5% with 10x leverage, you've made $500 (5% of $10,000). With a 5% price increase, you made 50% of your $1,000 margin. Profitable, right?
Cryptocurrencies are volatile, thus your asset's price could drop at any time. In the example above, a 5% reduction in your asset's price costs $500, or 50% of your starting margin, resulting in a 50% loss.
Trading seeks profit. Leverage's profit-loss formula is simple:
Initial margin x (% price movement x leverage) = profit or loss.
Crypto margin trading always liquidates positions at market price. Leverage magnifies losses. If the trader loses $1,000 from the $10,000 open position, he loses his whole original margin. Before borrowing money to trade cryptocurrencies, you must understand the hazards.
How Does Crypto Liquidation Happen?
Crypto liquidation can occur in various ways, depending on the type of trading and the platform being used.
In margin trading, when the value of a trader's position drops below a certain level, the exchange may automatically sell off enough of the trader's assets to repay the borrowed funds and maintain a certain level of collateral. This is known as a margin call, and it is meant to protect the exchange from further losses.
In regular trading, liquidation can happen when a trader decides to sell their crypto assets for fiat currency or another cryptocurrency. This can be triggered by a variety of reasons, such as to realize profits, cover losses, meet liquidity needs, or due to changes in market conditions or personal financial circumstances.
In both cases, the process of crypto liquidation typically involves the transfer of the crypto assets to an exchange or brokerage, where they can be sold and the proceeds can be deposited into the trader's account.
Definition of the Liquidation Price
The liquidation price refers to the specific price at which a trader's margin position will be automatically closed by the exchange in order to repay the borrowed funds and prevent further losses. This price is determined by the exchange and is based on various factors, including the amount of margin borrowed the current market price of the asset, and the exchange's predetermined risk management policies.
In other words, the liquidation price is the trigger point at which the exchange will sell off enough of the trader's assets to repay the borrowed funds and maintain a sufficient level of collateral. If the market price of the asset falls below the liquidation price, the exchange will automatically execute the liquidation to prevent the trader from incurring further losses.
It's important for traders to understand the liquidation price when engaging in margin trading and to consider the potential risks involved, as a rapid decline in market price can result in forced liquidation and significant losses.
Examples of Bitcoin Liquidation
Bitcoin liquidation can occur in several ways, including the following examples:
- Margin trading: In the context of margin trading, a trader who borrows funds to trade Bitcoin may face a forced liquidation if the value of their position falls below the predetermined liquidation price. This means that the exchange will sell off enough of its Bitcoin holdings to repay the borrowed funds and prevent further losses.
- Profit-taking: A trader who has bought Bitcoin at a low price and is holding a profit may choose to liquidate their position and sell their Bitcoin for fiat currency or another cryptocurrency in order to realize their profits.
- Market volatility: In times of high market volatility, a trader may choose to liquidate their Bitcoin holdings in order to reduce their exposure to price swings and minimize their potential losses.
- Changes in personal financial circumstances: A trader may need to liquidate their Bitcoin holdings to meet unexpected expenses or other financial needs, such as paying bills or covering a sudden loss.
Example: When Bitcoin went below 43k in early January, $812 million in crypto futures were liquidated, causing significant losses for long crypto speculators. Because traders lost the initial margin, this happened.
Regardless of the reason, the process of Bitcoin liquidation typically involves transferring the Bitcoin to an exchange or brokerage, where it can be sold and the proceeds can be deposited into the trader's account.
How Can I Protect Myself From Crypto Liquidation?
There is no guaranteed way to avoid crypto liquidation, as it can be triggered by a variety of factors, including market volatility, changes in personal financial circumstances, or a drop in the value of a trader's position in margin trading. However, there are some steps that traders can take to reduce the risk of liquidation, such as:
- Understanding the risks: Traders should educate themselves on the potential risks involved in crypto trading and margin trading, as well as the factors that can trigger liquidation.
- Diversifying investments: Diversifying investments across different cryptocurrencies and other assets can help reduce the risk of losses from any single investment.
- Proper risk management: Traders should have a solid risk management plan in place, including setting stop-loss orders and using proper position sizing to limit their potential losses.
- Monitoring market conditions: Traders should regularly monitor market conditions and be prepared to adjust their investments as needed to reduce their exposure to risk.
- Seeking professional advice: Traders who are unsure about the risks involved in crypto trading and margin trading may benefit from seeking professional advice from a financial advisor or trader.
It's important to note that crypto trading, including margin trading, carries significant risks and is not suitable for all investors. Traders should carefully consider their personal financial circumstances and risk tolerance before engaging in any type of crypto trading.
Conclusion
Understand liquidation and how to avoid it before trading bitcoin. Crypto liquidation occurs when an investor cannot meet their leveraged position's margin. Exchange borrowing boosts traders' funds.
Leveraging or borrowing cash to expand trade positions is dangerous and can increase losses as well as rewards. By monitoring margin, leveraging responsibly, and employing stop-loss and limit orders, you can avoid liquidation.
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