Why you should never use your Liquidation Price as a Stop Loss on Bitcoin Futures

Austerity Sucks
Feb 18, 2017 · 6 min read

One of the most important technical factors to successful trade setups is using proper stop losses on positions. We are all trading on _some_ kind of leverage, whether it’s 6x on CryptoFacilities or even 100x on BitMEX. Proper risk management in this context separates the plebs from the consistently successful traders.

Background

First, a little background for the less experienced traders. When we talk about “something X” (6x, 10x, 20x, 50x, 100x)…leverage in bitcoin trading its the same as (100/amountX)% initial margin requirement. In effect we are talking about how much equity you need to put down to take a certain position. This is also known as “initial margin”, i.e., the initial amount of margin needed to make a trade.

As an example, let’s say you want to trade $100,000 worth of inverse contracts. All bitcoin futures exchanges are bitcoin-based and use inverse pricing. So you need to put down a percentage of the value (in bitcoin) to cover your trade. On OKCoin 20x you would put down 5%, or $5,000 (around 5 bitcoin). On BitMEX at 100x you would put down 1% of the position size, or $1,000 (around 1 BTC at current prices).

BitMEX contract specifications showing a 0.5% maintenance margin requirement.

Maintenance Margin

Now the way the futures risk management systems work is they require this initial margin at open, but they also require that you hold a minimum amount of equity (the market value of your position vs the initial margin you put down) to keep the position “alive”. FOREX and other legacy markets are liquid enough that when you hit maintenance margin then your broker liquidates you at market price and you get the leftover of maintenance margin vs. loss on position from liquidation price and mark price.

But socialized loss high leverage counterparty bitcoin derivatives exchanges are different. From the exchange’s point of view, they want to make sure that you are able to keep paying the profits of the person on the other side of your trade. But if you put down $5,000 on your $100,000 position at OKCoin, for example, you will get margin called once you have only $1,000 in margin left. This is so the exchange can take over your position and aggressively sell it into the books so it gets cleared. They also put any amount of money earned on the liquidation (they put a limit order at the liquidation price, and it often fills at a better price due to market demand) into an insurance fund.

Jack, Chief of OKCoin International, describing the futures risk management system with 1% maintenance margin

On BitMEX a similar system exists where at 0.5% (not 1%) of the position size you are liquidated is taken from your position upon liquidation in order to cover the spread to push it into the market, and build a liquidation fund to help smoothen forced liquidation processing.

CryptoFacilities similarly has thresholds for liquidation, but because they have a strictly no socialized loss risk system, they actually return any remaining equity to the trader, unless in case of termination where the portfolio value is transferred to the winning trader (that’s a whole different story.)

CryptoFacilities margin requirements on their high leverage contracts

Use a Proper Stop Loss

The reason I’ve gone over all this background about initial margin and maintenance margin is to illustrate a point about setting proper stop losses. Because OKCoin and BitMEX will take your maintenance margin, you want to avoid the situation of getting liquidated under any circumstance. A lot of people use the “Fixed” or “Isolate” feature to prevent their whole account balance from being used in a position and reducing the blowout when the market goes against you. However, you’re still sacrificing your maintenance margin unnecessarily on a position by getting liquidated rather than getting out beforehand.

Let’s say you’re long 1,000 contracts at 20x Fixed margin at price of $1,050 on OKCoin, $100,000 worth. Contracts at OKCoin are inverse and worth $100 a piece. Your liquidation price on this position then is $1,009.62, about $40 below your entry:

If you were using 20x, then the amount of margin you put down for this position would be 4.762 BTC at current prices (index price is $1,050):

This is the 5% “initial margin” mentioned earlier (4.762 is about $5,000, 5% of the $100,000 position of 1,000 contracts). But look at the profit/loss column when I enter a closing price of $1,010, which is JUST above our liquidation of $1,009.62. It is -3.77 BTC lost on the position. So by getting out of the position right before your margin call would have occurred, your 4.762 BTC is taking a -3.77 hit, but you still have almost 1 BTC left (about $1,000 or 1% of the position value). This is the “maintenance margin” we mentioned that the exchange takes from you upon liquidation. The value of getting out of your position before liquidation hits in this case is saving 1 BTC. So this is not trivial, you get to save 20% of your equity on the trade rather than paying the insurance fund/other traders!

BitMEX, it can be argued, hits you with an even harsher penalty if you ride your position to liquidation rather than getting out right before your margin call price. Let’s go through a similar $100,000 position at full 100x leverage. This is obviously not advised and BitMEX will tell you also that most traders do not use this. But let’s see:

To make the 100,000 contract position at $1,050 you need 1.1 BTC margin. This is a little more than 1%, because it also has to cover the exit fee on the position as well as potential funding. When you’re long your liquidation price is $1,044.78 — this is a little more than $5 below your entry price:

So once the mark price on BitMEX reaches $1044.78 you lose the 1.1 BTC in margin, you’re liquidated, “rekt” as the kids say. You see none of that margin ever again. However, if you were to sell out of the position at $1,045, just above the liquidation, your Profit/Loss on that is -0.456 BTC:

By getting out right before liquidation, your 1.1 lost -0.456 BTC, and you still have 0.65 BTC left to play with. That’s a lot better than letting your position get liquidated so you have 0 left, right? In liquidation you’d lose the 0.65/1.1 — over 50% of your equity put down on the trade!

Summary

High leverage bitcoin futures exchanges have to use “maintenance margin” in order to manage the system risk of their products. This means they will liquidate you when your equity on a position goes below this level, and you will not see the funds again.

Using a proper stop loss on a position instead of a liquidation price will save you a significant amount of money. The higher leverage you use, the higher the hit is as a percentage of youre equity you put down. At OKCoin 20x the hit is 20% of your equity. At BitMEX 100x, the hit is 50% of your equity.

As I demonstrate above, a $100,000 position on OKCoin at 20x, when you get out before liquidation, will save you 1 BTC at current prices. The same $100,000 position on BitMEX at 100x will save you about 0.65 BTC if you get out with a stop loss before your liquidation.

Save your money by getting out of position BEFORE you get margin called/liquidated.

There is no substitute for a properly set stop loss on a position.

Austerity Sucks

Written by

I'm co-admin of Whalepool.io and do stuff with cryptocurrency derivatives.

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