DeFi 101: Margin, Leverage and Liquidations in Derivatives Trading Part 2
In the previous post, we explored margin and leverage trading, and how you can differentiate between them. Now we’re gonna dive more into liquidation and how it works.
If you missed the last post, catch up here.
How does liquidation work?
A number of factors determine the liquidation price — the leverage ratio, the position you open, and the funds in your account to maintain your position. Usually, at the point of opening a leveraged position, the exchange platform automatically calculates the liquidation price. You should note that, the higher the leverage, the lower the percentage in price change needed to trigger liquidation. For instance, you open a position of 100x leverage (1:100) with an initial deposit of $1,000 which qualifies you for a $100,000 opening position.
An opposite price direction of say 1% would trigger liquidation automatically because the margin balance is running at a loss. As the spot prices change, so does the value of your notional contract size. When the notional value goes below a minimum amount required in order to maintain your position, then you usually get liquidated. The exact calculations and steps vary across exchanges, so be sure to do your ample homework.
Platforms liquidate a trade to help protect you from losing more money beyond your initial margin. Many platforms ask that you increase your collateral once margin balance goes below the minimum threshold value needed to maintain that position. This is referred to as a margin call. They do this to make sure your position is secure. However, most platforms forcefully close your position once the price falls to the liquidation price set. Hence you lose your initial deposit plus any amount you owe from the collateral you put up to open that position. This is when you get rekt. Lots of mechanics here, but it all makes sense once you get the hang of it.
As much as margin and leverage trading provides greater opportunities for profits, you stand to lose just as much It’s a high-risk and high-reward play. Thus, you must develop a cautious approach to trading. Only open a leveraged position with money you can afford to lose. Start with low leverages to make sure you know what you’re doing. Caution remains the key word here — as always DYOR cause these are not financial advice!