In this article, you will learn what is liquidation. Bitcoin and other cryptocurrencies are renowned for being high-risk investments prone to extreme price swings. Adding to this volatility is the potential to increase the size of crypto trading positions through the use of derivatives products like margin trading, perpetual swaps and future' something very important to note here. This type of trading is a two-edged sword and you will need to take care of your assets being liquidated.
What Is Liquidation?
In the context of cryptocurrency markets, liquidation refers to when an exchange forcefully closes a trader's leveraged position due to a partial or total loss of the trader's initial margin. It happens when a trader is unable to meet the margin requirements for a leveraged position. Liquid Occurs in both margin and futures trading.
Trading with a leveraged position is a high-risk strategy, and it is possible to lose your entire collateral (initial margin) if the market makes a large enough move against your leveraged position. In fact, some countries like the United Kingdom consider it so risky it has banned crypto exchanges from offering retail investors leveraged trading products to protect novice traders from being liquidated and losing all their invested capital.
You can keep track of the percentage the market needs to move against your position it to be liquidated by using this formula:
Liquidation % = 100 / Leverage
For instance, if you use 5x leverage, your position will be liquidated if the price of an asset moves 20% against your position (100/5 = 20.)
How to Avoid Liquidation?
When using leverage, there are a handful of options available to mitigate the chances of being liquidated. One of these options is known as a “stop loss.”
A stop-loss, otherwise known as a “stop order” or “stop-market order” is an advanced order that an investor places on a crypto exchange, instructing the exchange to sell an asset when it reaches a particular price point.
When setting up a stop loss, you will need to input:
- Stop price: The price where the stop loss order will execute
- Sell price: The price at which you plan to sell a particular crypto asset
- Size: How much of a particular asset you plan to sell
If the market price reaches your stop price, the stop order automatically executes and sells the asset at whichever price and amount stated. If the trader feels the market could move quickly against them, they might choose to set the sell price lower than the stop price so it's more likely to get filled
Where to Set Stop Loss?
Placing stop losses correctly is vitally important, and while there is no golden rule for setting a stop loss, a spread of 2%-5% of your trade size is often recommended. Alternatively, some traders prefer to set stop losses just below the most recent swing low.
The higher your leverage, the higher your chances of being liquidated. Using excessive leverage is akin to exposing your capital to unnecessary risk. Moreover, some exchanges manage liquidations aggressively.
Bottom Line
Due to the risk associated with leverage trading, some exchanges have moved to lower the limit traders can access. But you will need to take care of liquidation so, this is about what is liquidation.
