Liquidation is a feature of futures exchanges that helps both users and the exchanges themselves manage risk.
Because in leverage trading a user is effectively borrowing funds from an exchange, there are certain mechanisms put in place to keep traders from experiencing negative equity (i.e. losing more than one’s deposit). This is done by establishing thresholds past which one’s leveraged trade cannot go; this is called the “liquidation price”. When a leveraged position must be closed because a debt limit is reached, the user forfeits their collateral and experiences “liquidation”.
A liquidation event occurs when a trader has insufficient funds to keep their leveraged trade open, so their margin is taken in order to protect the exchange from losing money. The price at which a trade is liquidated is calculated automatically by the exchange, and if this liquidation price is hit, the collateral is automatically sold, taking the trader’s initial funds from their account. The liquidation price is also dependent upon the amount of leverage and amount of remaining funds inside the account. While liquidation is not a desired outcome for any leveraged trader, it keeps the trader from going further and further into debt.
How can you avoid being liquidated?
- Traders can add more funding to their account in order to lower their liquidation price and avoid being liquidated. Sometimes this can be a slippery slope (as you are effectively potentially digging yourself a deeper hole if you get liquidated) but it does help you avoid immediate liquidation for your position.
- Place a stop loss order in order to minimize losses. When your price target for a stop loss order is hit, your position will be sold at a loss to stop any further losses.
- Pay close attention to your margin ratio. If you hit a certain margin ratio you will be liquidated so you want to ensure that you are at a healthy margin ratio.
- New traders should avoid leverage as it’s a very risky trade, and, if you are not an experienced trader, it is easy to lose all of your funds.
As leverage trading is the highest risk trade one can make, there are large risk factors (e.g. liquidation) that can become costly if one makes a bad trade. Many traders who are using leverage will get liquidated during times of high volatility in cryptocurrency markets. Often in crypto the price will increase or decrease rapidly in one direction, due to the liquidations and leverage of long and short traders. Make sure you pay close attention to the leverage ratios for the entire market to understand how much risk traders are currently willing to take on at any given time.