What is liquidation on crypto exchange?

At some point in your cryptocurrency futures trading, you are bound to experience a liquidation event where your position is forcibly closed. Let’s look more closely at liquidation examples and ways to avoid them.

An overview of core principles of position liquidation during margin trading in crypto exchanges.

Thanks to margin trading, a trader can use the cryptocurrency borrowed from the exchange. Naturally, nobody lends money for nothing — an exchange client gives a pledge (Initial Margin) for capital management when opening a trading position. In order to protect itself from losing money, each trading platform has the right to start the process of liquidating.

What is Margin Trading?

Margin Trading is trading using third party funds (in this case exchanges). The value of borrowed funds relative to the collateral is determined by the leverage. For example, to open a deal for $1,000 with a leverage of 10:1, a trader will need to open a position for $100 of his capital. That is, in this case, the amount of own funds should be less than ten times.

Each platform has its own conditions regarding leverage. For example, in the stock market most often used the leverage of 2x, Forex brokers can offer values up to 200x in some cases. At BitMEX, Binance and many other crypto exchanges clients can open a position with up to 100x leverage. By the way, Binance Futures platform provides 125x leverage.

What is position in Margin Trading?

There are two types of positions: long and short. In the first case, the trader expects to profit from the growth of the asset’s price, in the second — from its decrease.

If the value of a cryptocurrency moves in the direction predicted by the trader, he can fix the profit on the deal, and the profit increases in proportion to the leverage taken by the trader. After closing a deal, the borrowed money with fee is returned to the exchange, and the user receives the rest.

Example: a trader opens a long position of 1000 dollars with the leverage of 10x. The total amount of the transaction is ten times higher than his position, that is, if the price rises by 1 percent, the profit will be equal to one hundred dollars. The trader decides to close the position and his account is funded with the earned one hundred dollars minus commission. If he made exactly the same deal without any leverage, he would earn only $10 minus fees.

The opportunity to increase their profits by ten or even a hundred times attracts amateurs to get easy money. Trading is not easy, so most people lose their money because of the liquidation mechanism. Around 90% of all traders lose their money in the long run. It is almost impossible to stay in the game if you are a beginner.

It is noteworthy that in case of liquidation, the exchange can also get some profit. BitMEX sends these funds to an insurance fund, and Binance sends them to pay interest on leasing transactions.

How to calculate Liquidation price?

When opening a leveraged trading position, its liquidation price is automatically determined. If the cryptocurrency price crosses this mark, the position is automatically liquidated.

The liquidation price depends on the trader’s position, the leverage and the amount of remaining funds in his account. There is no need to calculate the mark manually — the exchange will calculate everything for you. For example, in the case of BitMEX or Binance, you can use the calculator to calculate the liquidation price.

Example: you deposit 0.01 BTC and open a 1 BTC order, i.e. your 100x leverage. Something goes wrong and the Bitcoin price goes in the opposite direction to the one you need only 1 percent. Because of this movement your position is unprofitable by 0.01 BTC, i.e. by the value of your margin. A little more and the exchange will be in a loss, so the liquidation algorithm automatically closes the deal.

Keep in mind that the higher the leverage, the lower the percentage of price change will lead to the position liquidation. That is, if you have opened a trade with 50x leverage, a price movement of only 2% in the opposite direction will cause liquidation.

It is recommended not to use the leverage above 10x, and beginners should not try to trade with a margin above 2x.

When opening a long position, the liquidation price is placed below the opening price. Accordingly, for an open shorts position, liquidation will occur if the asset price reaches a certain point above the entry price.

Liquidation stages

In cases where the exchange is unable to liquidate positions before the trader reaches a negative balance, the following methods will be used to cover the losses of bankrupt positions:

• Insurance fund: A fund that is maintained by an exchange in order to allow traders to make their full profit and to ensure that a trader who has gone bankrupt does not incur unnecessary losses;
• System of “Socialized Losses”: This method distributes the losses of bankrupt positions to all profitable traders;
• Auto-deleveraging (ADL) liquidation: With ADL, the exchange chooses market positions of traders based on priority, taking into account the amount of profit and leverage, and automatically closes their positions to cover other positions.

What is an insurance fund?

Insurance funds protect bankrupt traders from unfavorable losses and guarantee that other traders will get their profits. The main purpose of the insurance fund is to limit the cases of liquidation through auto-deleveraging (ADL). With ADL, traders’ positions are automatically liquidated to cover the position of the bankrupt trader. In such situations, opposite positions with high leverage are likely to be liquidated through auto-deleveraging.

Insurance funds are replenished with liquidated positions. When an order is liquidated at a price lower than the bankruptcy price, the positive difference goes to the insurance fund.

The insurance fund model is not unique for cryptocurrency exchanges. Traditional exchanges, such as CME and CBOE, also have protection systems, more than those of the cryptocurrency exchanges, and can support several default values. These guarantee systems involve multiple parties, such as clearing centers and clearing participants, and typically require higher collateral than unregulated exchanges.

How to avoid Liquidation?

It is important to understand that a trader does not have to use all his capital as collateral to open a margin position.

There are two types of leverage: isolated and cross margin. In the first case, collateral for the transaction is limited only by the pledge itself. In other words, in case of liquidation, the exchange will not withdraw all funds from the account. Isolated margin is suitable for those who hold only one position. In this case, even after opening a transaction, a trader can change the leverage on the move, increasing his initial collateral from the remaining funds in his account.

Cross Margin or “Spread Margin” can use the entire balance of the client (Maintenance Margin) to avoid liquidation. That is, the profit made on one trade will automatically cover the loss on another one opened at that very moment. This type of leverage is suitable for traders who have several trades on different trading pairs at once or who are involved in arbitrage — that is, when they are trying to make a profit from the difference in the exchange rates of different exchanges.

The easiest and most effective way to avoid liquidation is to place a stop loss order (specify the level of suitable liquidation to minimize losses), which will allow you to close the position in advance in a small drawback if something goes wrong. Even though an isolated margin allows you to move the liquidation price to a loss-making position on the move, it is best to use stop loss orders.

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