What Is Liquidation In Crypto Futures and How to Avoid It?
The rising popularity of cryptocurrencies has spurred an increased interest in crypto derivatives trading. This trend has been further fueled by the prospect of achieving substantial gains through leveraged accounts. However, engaging in such trades requires caution and skill as any mismanagement can result in liquidation and loss of funds.
While the appeal of cryptocurrencies lies in their inherent volatility, it is important to noe that leveraging can amplify both potential profits as well as losses, increasing the risk of crypto liquidation.
Crypto liquidation is a dreaded scenario for traders who employ leverage. It occurs when the value of an investor’s position falls below a predetermined threshold, leading to automatic closure of the position and loss of funds.
What Is Liquidation in Crypto Futures Trades?
While liquidation typically refers to the process of converting assets into cash, it has a different meaning in futures trading where it is something traders strive to avoid.
In cryptocurrency trading, liquidation occurs when a trader’s position is automatically closed due to insufficient margins to cover ongoing losses. This situation arises when traders fail to maintain the necessary margin requirements for their leveraged positions. Consequently, their position is automatically liquidated as they do not have enough funds to keep their trades open.
The liquidation of assets can occur either voluntarily or through a forced process. Voluntary liquidation is typically pursued to raise cash for new investments, close out old positions, or finance purchases. On the other hand, forced liquidation may be required in bankruptcy proceedings, whereby an entity is compelled by legal judgment or contract to convert assets into cash.
How Does Crypto Liquidation Happen?
To better understand how crypto liquidation happens, let’s consider an example. Assume you have $500 in your trading wallet and choose to use a leverage of 10x, allowing you to open up a $5,000 trading position. If your trade gains 5%, your profit will be $250. However, if the trade results in a 2% loss, your initial margin will decrease by $20.
Should the loss continue without a proper crypto risk management strategy to mitigate the loss and the price moves against you by just 10% more, the broker will have no choice but to liquidate your position. Without leverage, you would have only had a 10% loss. This highlights the risks associated with leveraged trading.
To prevent crypto liquidation, exchange platforms typically make margin calls before liquidating accounts. A margin call is a demand by your exchange for you to deposit extra funds to prevent your position from being closed. If you fail to add more funds to the margin account, your account may be liquidated. However, there may be no liquidation if the trader can add more funds to cover the losses to the account.
How to Avoid Liquidation
To mitigate the risk of liquidation when using leverage, traders have several options at their disposal, including the use of a “stop loss” order and monitoring margin ratio.
Stop loss order
A stop loss, also referred to as a “stop order” or “stop-market order,” is an advanced order placed by an investor on a cryptocurrency exchange, instructing the exchange to sell an asset at a specific price point.
To set up a stop loss order, traders must input three key parameters: the stop price, sell price, and size. The stop price is the point at which the stop loss order will execute, while the sell price is the desired selling price for the asset. The size parameter represents the amount of the asset that the trader plans to sell.
If the market price reaches the stop price, the stop order will be automatically executed, and the asset will be sold at the specified price and size. Traders may opt to set the sell price lower than the stop price to increase the likelihood of the order being filled in the event of a rapid market downturn.
The primary goal of a stop loss order is to minimize potential losses.
Monitor your margin ratio
A useful way to manage your risk without using a stop order is to manually monitor your margin ratio. This involves calculating the liquidation percentage, which is determined by dividing 100 by your leverage.
For instance, let’s say you open a trade with an initial margin of $100 and a leverage of 5x, which creates a position worth $500. Applying the formula above, your liquidation percentage would be:
20% = 100 / 5
This means that your position would be liquidated if the asset’s price moves against your position by 20%, resulting in a decrease in value from $500 to $400.
By monitoring your margin ratio manually, you can stay on top of your trades and make informed decisions about when to exit a position to avoid liquidation.
Wrapping Up
Although leveraged trading can result in significant profits, it can also lead to liquidation if the market moves in the opposite direction. This is especially true in the highly volatile crypto market, making risk management critical for traders to limit potential losses. By implementing a proper strategy, traders can navigate the market confidently, focusing on long-term success rather than short-term setbacks.
Disclaimer: The opinions expressed in this blog are solely those of the writer and not of this platform.
