What Is Liquidation in Crypto Trading and How Do You Avoid It?
Reading Time: 4 minutesIf you overextend, you’ll get liquidated; it’s as simple as that.
The popularity and growth of cryptocurrencies have drawn many people’s attention to cryptocurrency trading. Additionally, the possibility of making larger profits with a leveraged account has increased people’s interest. However, mismanaging a trade can result in liquidation, where you lose all of your money.
So, what is crypto liquidation, and how can you avoid it?
What Is Crypto Liquidation?
Cryptocurrency liquidation occurs when a trader’s position is forced to close owing to insufficient margin to cover an ongoing loss. It happens because traders fail to cover the margin requirement for their leveraged position. Therefore, a trader’s position will be automatically liquidated since they do not have enough money to keep their trades open.
Liquidation can be either forced or voluntary. A forced liquidation is the automatic closure of a position when a trader fails to maintain the required funds for the position. On the other hand, voluntary liquidation is when traders decide to remove their funds from a losing trade. It also comes with the privilege of gradually closing their leveraged positions. A forced liquidation is executed by the lender, which is the exchange platform, while the trader executes a voluntary liquidation.
Leverage and Liquidation
Leveraging your account has advantages because it allows you to profit from small price movements. However, if you do not take precautions, it can be a major disadvantage since it exposes you to more risks. A sudden price change can turn a profitable trade into a huge loss if not managed well.
Leveraging in crypto trading means borrowing extra funds from an exchange platform to take on trading positions your current capital can’t give you. Before you are loaned additional funds, the exchange platform will request collateral, meaning you must render some of your capital. This collateral is called the ‘initial margin.’ Liquidation occurs when you cannot meet the margin requirements for your position(s). With leverage, liquidation can even happen faster.
Assume you have $100 in your trading wallet and choose to use a leverage of 10x. Your positions will automatically be multiplied by 10, so you can open up a $1,000 trading position. In addition, your profit and loss will be ten times bigger than they would have been without leverage. For example, let’s say you go long on BTCUSD (you bet the market will move upwards). If your trade gains 5%, with the leverage, it would return $50, meaning that with only a 5% movement, you have made half of your initial margin. That’s a lot, right?
On the other hand, if the trade results in a 2% loss, your initial margin will decrease by $20. Should the loss continue without a proper crypto risk management strategy to mitigate the loss and the price move against you by just 10%, the broker will have no choice but to liquidate your position. Without leverage, you would have only had a 10% loss.
Exchange platforms make margin calls before liquidating accounts. A ‘margin call’ is a demand by your exchange for you to deposit extra funds to prevent your position from being closed. If you fail to add more funds to the margin account, your account may get liquidated. However, there may be no liquidation if the trader can add more funds to cover the losses to the account.
Types of Liquidation
There are two types of liquidation, with their major difference being the extent to which your trading positions are closed out. They also relate to forced liquidation and voluntary liquidation.
Partial Liquidation
Partial liquidation involves closing out a portion of your position to reduce your exposure to risk. This type of liquidation is usually voluntary, and the trader does this not to lose his whole trading stake.
Total Liquidation
Total liquidation involves the selling of your entire trading balance to cover losses. It typically occurs in cases of forced liquidation when the trader fails to meet the margin call requirement. In such situations, the exchange will automatically close out the trader’s positions to cover the losses.
In some severe cases, liquidation may lead to a negative balance. Some exchanges cover such losses by employing different methods, of which settling them with insurance funds is one of the most popular.
Insurance Fund
To cover losses from bankrupt positions, certain cryptocurrency exchanges utilize various methods, one of which involves using insurance funds. These funds act as a form of protection for exchanges, allowing them to cover losses and allocate enough resources to compensate profitable traders. In the event of bankruptcy, when the liquidation price surpasses the initial margin, the insurance fund will be used to absorb the loss, safeguarding crypto traders from acquiring a negative balance.
2 Ways to Avoid Liquidation
There are some methods that you can practice that will help mitigate liquidation risk.
1. Determine Your Risk Percentage
Deciding how much money you’re willing to lose and what percentage of your trading account you’re willing to risk per trade is important. Experts suggest not risking more than 1% to 3% of your account on a single trade. For example, if you risk 1% of your account on each trade, you would have to lose at least 100 trades in a row to lose your account.
So, what is leverage for? Leverage can help you achieve your price goal with small changes in the price of your investment. This means you can reach your target faster than if you didn’t use leverage.
2. Always Use a Stop-Loss
When trading, it’s helpful to use a stop-loss order to reduce the amount of money you might lose if the market goes against your expectations. For instance, if you set a stop-loss order at 2% below the entry price, any potential losses will be capped at that level if the trade doesn’t go as planned. However, because the crypto market can be very unpredictable and volatile for different reasons, without a stop-loss order, losses can get out of control and may cause you to lose a lot of money or even all of your trading funds.
Apart from limiting potential losses, stop-loss orders keep you from making rash decisions during market instability. The majority of crypto trading platforms provide this feature at no additional cost. However, it’s crucial to remember that using a stop-loss order doesn’t guarantee you’ll make a profit when trading, as this depends on the quality of your decision-making. Still, the order can help reduce the pace at which you lose money.
Always Manage Risks to Avoid Liquidation
Leverage positions can result in a quick profit, but they can also result in liquidating your account with a single poor trade. Therefore, it’s wise to use reliable trading tactics along with risk management techniques like stop-loss orders and predetermined trade risks to mitigate the chances of liquidation.
Reference: https://www.makeuseof.com/what-is-liquidation-crypto-trading-how-do-you-avoid-it/
Ref: makeuseof
MediaDownloader.net -> Free Online Video Downloader, Download Any Video From YouTube, VK, Vimeo, Twitter, Twitch, Tumblr, Tiktok, Telegram, TED, Streamable, Soundcloud, Snapchat, Share, Rumble, Reddit, PuhuTV, Pinterest, Periscope, Ok.ru, MxTakatak, Mixcloud, Mashable, LinkedIn, Likee, Kwai, Izlesene, Instagram, Imgur, IMDB, Ifunny, Gaana, Flickr, Febspot, Facebook, ESPN, Douyin, Dailymotion, Buzzfeed, BluTV, Blogger, Bitchute, Bilibili, Bandcamp, Akıllı, 9GAG