What is Liquidation In Crypto Trading and How to Avoid it?

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What is Liquidation In Crypto Trading and How to Avoid it?

What is Liquidation & How can you avoid it | BitDelta

Table of Contents

Introduction

Though crypto trading is becoming increasingly popular because of the potential of crypto assets to give profits, it is a highly risky endeavor due to the speculative and volatile nature of cryptocurrencies. On this note, both short-term traders and long-term investors should ensure the best trading practices to gainfully navigate the cryptocurrency market.

Various are the types of cryptocurrencies that can potentially lead users to generate profits:

  • Spot Trading
  • Arbitrage Trading
  • Margin Trading
  • Futures Trading

Each of these trading types differs in mechanics and risk level, leaving traders and investors to choose the ones that suit that capacity and personality.

Derivatives trading including margin and futures trading has garnered enormous adoption and patronage from crypto traders over the years. Unlike spot trading, derivatives trading allows its market participants to trade with leverage, increasing traders’ chances to make both high profits and losses in a matter of minutes, hours or days. But don’t be fooled by the numbers derivatives trading can bring because this is where the concept of liquidation comes into play.

If you think of the worst thing that could happen to a derivatives trader, getting liquidated would be at the top of the list. While missing an entry, hitting stop-loss or failing to close a position at the right time may not be a big deal for a trader, experiencing a liquidation is a disaster no derivatives trader wants to face.

Whether you are an existing or intending crypto trader, this article will help you understand the concept of liquidation and how to avoid falling into it.

Liquidation Explained

The core definition of liquidation differs from one context to another, but the underlying concept remains the same. In traditional business, liquidation refers to the process of bringing a company to an end and distributing its assets to claimants. It usually happens once a company becomes insolvent.

To liquidate also refers to the process of converting property or assets into cash or cash equivalents by selling them on the open market.

In derivatives trading — whether margin or futures — leverage is often used, allowing traders to control larger positions with a smaller amount of capital.

When a trader enters a leveraged position, a minimum amount of collateral is to be maintained, which is known as the maintenance margin. If the value of the trader’s position moves against them to a certain extent, reaching the liquidation price, the exchange will automatically close the position to prevent further losses. This act is known as crypto liquidation, and only happens in margin and futures trading. 

Liquidation in crypto trading happens when a trader’s position(s) is forcefully closed by an exchange due to insufficient margin balance or collateral to cover ongoing losses.

Simply put, liquidation is a scenario where a trader in any derivatives market loses all the balance or funds in his trading account, leading to a zero balance.

What Causes Liquidation?

While many factors can trigger a liquidation, it mainly happens when a trader is unable to meet the margin requirements for a leveraged position. In other words, liquidation occurs when a trader fails to have sufficient funds to keep the trade open.

Liquidation typically occurs when the (mark) price of the asset being traded reaches the liquidation price. The liquidation price is determined by the crypto exchange based on many factors:

  1. Leverage level
  2. Number of positions entered
  3. Position sizes
  4. Prices of cryptocurrencies being traded

The exchange will automatically sell or close out the trader’s position to repay the borrowed funds and any associated fees when the mark price equals the liquidation price.

When liquidation happens, it normally involves the trader selling his assets at the current market price.

The proceeds from the liquidation are then used to cover the losses incurred in the position. Moreover, by liquidating the position, the exchange can ensure that borrowed funds are returned, and the remaining collateral is available for other traders.

Liquidation - Can it Be Avoided?

Now that you know what liquidation is, how it occurs and factors that can trigger it, let’s dive into how to avoid liquidation while trading in the derivatives market.

Below are some important steps and strategies you can follow:

Understand and Set Risk Parameters:
As you engage in margin/futures trading, it’s important to understand the risk involved, which is much higher compared to spot or arbitrage trading.
This is why defining your risk tolerance and setting precise risk measures before getting started is crucial. By determining the maximum amount of capital you are willing to risk on a certain position, only then will you be avoiding potential losses.

Proper position management and sizing:

By adequately managing the number of positions you enter at a time, you can protect yourself against liquidation. While there is no standard for the number of positions a trader can enter, it is important to moderate it, keeping in mind the size of capital (otherwise known as margin balance).

Likewise, the percentage of the initial capital or margin balance used per position should be kept low to keep the liquidation price distant from the mark price. Remember, the higher the position size, the higher the chances of being liquidated.

Avoid high leverage:

While using high leverage can increase your potential profits, it can also trigger a faster liquidation of your trading account, especially when your predictions fail. It is always advised to use low leverage when trading in the derivatives market.

Use Stop-Loss:
As the name implies, the feature helps to minimise losses or outright liquidation. The stop-loss order allows you to set the amount you are willing to lose in an instance where the market goes against your initial expectation.

A stop-loss order is an instruction to sell a cryptocurrency when it reaches a certain price level. It is advised to implement stop loss orders for each of your traders, as it helps limit your losses by automatically closing the trade if the price moves against you.

Market monitoring:
Regularly monitoring the price movements of traded assets and the overall crypto market conditions helps you address any market movements in a more responsible way – thus avoiding the loss of your entire margin.

Stay in the knowledge:

Trading requires a deep understanding of the markets and strategies implemented – whether technical analysis and/or fundamental analysis.

Understanding technical analysis, chart patterns, and market indicators can help you to preserve your profits and capital.

Conclusion

Making profits is certainly the goal of many traders and investors, but learning to preserve both your capital and profits should be your top priority in all crypto markets.

Trading knowledge isn’t built in a day or two – it takes several months of hardwork and dedication to become somewhat of an expert. Hence why every trader has the responsibility of learning proper risk management techniques to be able to make the most out of their trading journey.

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