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Liquidation in Crypto – What is It & how does it work?

The volatile nature of cryptocurrency makes it very prone to liquidation. Liquidation, which occurs when a crypto investor is unable to satisfy the margin conditions for their leverage position, is one of the banes of cryptocurrency. During the liquidation period, it is common for investors to borrow to increase the funds for their trading. However, this is a risky move, especially if the crypto market moves against your already leveraged position. Here, we will take a look at the meaning of liquidation in crypto and other important details you need to know about crypto liquidation.

The-best-crypto-exchange-platform
The-best-crypto-exchange-platform

What Is Crypto Liquidation?

Crypto Liquidation or liquidation in crypto is simple a strategy whereby an investor sells off their crypto assets for money to reduce losses during a market crash. However, the term ‘liquidation’ in the crypto space means something different. Liquidation is the forced closing of an investor’s position because of the loss of the investor’s initial margin. Usually, liquidation occurs when a trader is unable to fulfil the margin conditions for their leveraged position. For instance, if a trader lacks funds to keep the trade open, this can lead to liquidation. 

Margin requirements become underfunded when there’s an abrupt drop in the price of the underlying asset. When this occurs, the crypto exchange automatically closes the position and this leads to a loss of funds for the trader. In some cases, it can even lead to an absolute investment loss for the investor. 

What are the types of crypto liquidation?

There are two categories of crypto liquidations. It can either be partial or total liquidation. Here’s what you should know about each of them: 

1. Partial liquidation

Basically, this type of liquidation involves the closing of an investor’s position partially, early enough to decrease the position and leverage used by the trader.

2. Total liquidation

This type of liquidation involved the closing of an investor’s position completely. In this case, nearly all of the crypto trader’s initial margin has been used.

Liquidation can occur in futures and spot trading. However, traders should note that when acquiring a contract, the price is gotten from the asset. This clarifies the inconstancy of the asset’s profit and loss when converted to the current asset’s price. 

What Is Crypto margin trading?

What Is Crypto margin trading?
What Is Crypto margin trading?

Crypto margin trading is the process by which traders borrow money from crypto exchanges to fund their trading of a higher volume of assets. This provides the trader with more purchasing or leverage power, thereby increasing the capacity to make greater profits. In simpler terms, a trader’s ‘leverage’ is when they borrow money to go into a bigger position than their own money permits. 

Although borrowing money to increase the size of your trading position is a profitable idea, it is still very risky. If the crypto market moves against you, you may need to liquidate your assets quickly leading to greater loss.

In margin trading, any trader who wants to open a trading position will have to put up a specific amount of fiat currency or crypto in the exchange as collateral. This collateral is also called the “initial margin”. Basically, the initial margin insures the lender against abrupt loss if the trade doesn’t end well. The maintenance margin is the minimum margin needed to keep a trading position open. 

Exciting Read – Forex scams in Nigeria – Beware of these blacklisted brokers

How to calculate leverage

To calculate leverage, you use the amount of money you can borrow from a crypto exchange relative to the initial margin (collateral). For example, if you begin with an initial margin worth $1,000 and its 10x leverage, this means that you’ve borrowed$9,000 from the exchange to boost your crypto trading position from $1,000 to $10,000.

How to calculate leverage
How to calculate leverage

Also, the degree of leverage largely determines the possibility that a trade will make or lose money. Using the same leverage example above, if the price of your asset increases by 5%, you’ve earned 5% of $10,000, which is $500 from your trading position. So with only a 5% increase in price, you earn a profit of $500 which is a considerably reasonable gain. 

Unfortunately, there are chances that your asset’s price can drop abruptly due to how volatile cryptocurrencies can be. So using the same example above, let’s say the price of your assets drops by 5%, you’ll lose $500, which means you lose 50% of your initial margin ($1,000). This defeats the goal of trading. 

The formula that you can use to calculate the amount you can gain or lose during leverage is:

Initial margin × (% price movement × leverage) = profit or loss

It is important to note that when liquidation of positions occurs, they close at the current market price. So your losses increase based on the size of your leverage position. In simpler terms, if you lose $1,000 out of the $10,000 leverage position, you lose your whole initial margin. Hence, you must think carefully about the risk before borrowing money from an exchange to trade cryptocurrencies.

How does crypto liquidation happen? 

Crypto liquidation occurs when a crypto exchange or a brokerage closes an investor’s position since it can no longer satisfy margin requirements. Margin is a percentage of the entire trade value that an investor must deposit with a broker or an exchange to open and retain a position.

When an investor’s (trader) margin accounts drop below the previously agreed level, their positions will start liquidating automatically. When the leveraged position gets to the liquidation threshold, the investor will face a “margin call”. Essentially, the margin call means that the investor has to put up more margin. Usually, liquidation happens more during futures contracts, which require investors to make use of higher leverage amounts.  

At the liquidation threshold point, you have two options. It’s either you add more money to your margin to help increase leverage above the minimum leverage requirement or choose to forfeit your position. If you don’t add money to your margin to boost your leverage, the broker will liquidate your position automatically. 

Either you can add funds to your margin to bring your leverage back up above the leverage requirement, or the broker will automatically liquidate your position.

Continuing with our example of a $1,000 initial margin, let’s say you entered a trade with 10x leverage, which means your leveraged position is now $10,000 — that is, $1,000 of your own money and $9,000 which you’ve borrowed from the exchange.

For instance, if the price of Bitcoin drops by 10% and your leverage position is now worth $9,000. If the price continues to decline, and your position’s losses keep increasing, it will affect your borrowed funds. The crypto exchange will then have to liquidate your position to cut back on losses on the capital you borrowed. With this, they close your position and you lose your initial capital of $1,000.

Bitmama-crypto-card
Bitmama-crypto-card

What is the liquidation price?

The liquidation price is the exact point at which the exchange closes out your leveraged positions. Some factors that influence this threshold are leverage used, cryptocurrency price, maintenance margin rate, as well as your remaining account balance. Usually, crypto exchanges will automatically calculate the price of liquidation for you.

If your crypto asset price crosses the stipulated threshold for the liquidation price, it initiates the liquidation process. Cryptocurrency prices are always fluctuating, so it’s very crucial to stay ahead by keeping up with the latest price updates.

Examples of Bitcoin Liquidation

An investor may have to liquidate their Bitcoin to meet a financial emergency or cover a short position. When this occurs, the investor has to sell off their Bitcoin (asset) at the current market price, irrespective of if the current price is below or above the original purchase price. 

However, sometimes, Bitcoin investors may be compelled to sell their assets at a price that is below the market rate. This could end up as the liquidation price and depends on the crypto exchange on which the investor is selling Bitcoin.  

More importantly, you should know that liquidation prices fluctuate, depending on the condition of the current market. So if you want to sell your Bitcoin, it is ideal to study the latest liquidation prices before you make any final decision. Doing this ensures that you get the best possible deal.

Recommended – Beginners Guide to Understanding Crypto Signals

What is the difference between forced liquidation and liquidation?

The word “liquidation” just means the process of converting assets to cash. In crypto, forced liquidation refers to the involuntary changeover of crypto assets into cash or other cash equivalents (like stablecoins). 

Basically forced liquidation happens when an investor doesn’t meet the stipulated margin requirement the exchange set for leveraged positions. When this leverage condition is met, the exchange then sells off the investor’s assets automatically to make up for their positions.

The major difference between normal liquidation and forced liquidation is that the exchange closes investors’ positions automatically in forced liquidation, while regular liquidation is done voluntarily. Regular liquidation involves the investors closing their positions by themselves. A trader can choose to cash out of a cryptocurrency trade for numerous reasons.

Another fundamental difference between these two is that in a forced liquidation, all the positions are closed at once. However, this is not the same in the normal liquidation process. In a voluntary liquidation, exchanges allow investors to close their positions off gradually.

Although forced liquidation safeguards investors from incurring any extra losses, it can also be to their detriment. This is because all their positions are closed at once, which may lead to missed opportunities. On the other hand, regular liquidation, allows traders to have more control over their leverage positions since they are permitted to close them gradually. Nevertheless, this means that they’re at risk of greater losses if the market shifts against them.

Recommended – What is Stop Limit Order In Crypto?

How to avoid Crypto liquidation

Where there is no guarantee that you will win money on a trade, you can use smart trading strategies to help reduce your risk of losing. One good strategy is making use of lower leverage and also monitoring margins to avoid liquidation. Another one is using insurance funds as a means of reducing trading losses.

What are insurance funds?

What are insurance funds?
What are insurance funds?

An insurance fund is a pool of funds that a crypto exchange reserves to act as a defensive mechanism against outrageous loss. You can use it to protect the contract loss. 

Insurance funds act as safety nets that help to protect bankrupt traders from negative losses. However, making use of liquidation exit strategies can help to prevent this great risk in the first place. The purpose of having an exit plan is to reduce the amount of money lost. 

Examples of liquidation exit strategies include:

1. Stop-loss

Using the stop-loss order indicates the investor decides to close their position with a market order after the last traded price gets to a pre-determined price. The Stop-loss order serves as a defence to limit the possibility of loss that extends to the entry price. 

2. Trailing stop-loss

This is simply setting a stop-loss order to follow the last traded cost at an already-set price distance and direction. So when your last traded price gets to the peak and just moves in a single direction, it’ll then activate the trailing stop. Thereby limiting your losses and boosting unrealized profits if the market price shifts in your favor.

Lastly, reducing leverage, even if you do it slowly, is another good way to fight liquidation. However, the first step to take is to keep a record of liquidation prices, and of how near your positions are slipping below the stipulated margin.

Pay-bills-from-your-bitmama-crypto-wallet
Pay-bills-from-your-bitmama-crypto-wallet

Conclusion 

The paragraphs above have given a detailed definition of liquidation in crypto, how it works, as well as other things you need to know. The bottom line of everything is that you should be very cautious before you make any move as a crypto trader. Also, you can make use of the few strategies above to reduce your loss if you have to liquidate. 

As the best crypto exchange app in Nigeria, Bitmama offers a secure marketplace for crypto enthusiasts. Perform activities like crypto exchange, crypto staking, and creating virtual dollar or crypto cards for online payment. Get started today by downloading the Bitmama app on Android or iOS.

bitmama

Emmanuel

Feb 13, 2023

10 mins read

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