What is liquidation? How does liquidation work in crypto?

What is liquidation?

Liquidation is the event that happens to leverage traders who can no longer maintain their leverage positions. Liquidations usually occur in volatile markets as price fluctuations become increasingly high. In highly volatile markets like crypto, liquidations can cause the loss of as much as billions of dollars within a day.

Liquidation exists in both margin trading and futures trading.

How liquidation works

To explain further, in leverage trading, the trader borrows funds to increase position size for potentially higher profits. In this type of trading, their initial funds will be considered collateral. Once the value of the collateral gets outside the tolerable level, liquidation closes the position to ensure the integrity of the borrowed assets.

Let’s put it into an example.

For instance, Bob is a trader who opens a long position against Bitcoin (BTC) at $20,000, with an initial fund of $100. Considering $100 to be too small of a position, Bob uses leverage (borrow funds from others) to increase his position size. With a 10x leverage, Bob borrows $900 more to reach a position of $1,000.

In the ideal scenario, the price of BTC will go up, leading to Bob gaining massive profits. If the price of BTC becomes $22,000, indicating a 10% increase in price, Bob will receive 10% profits of his total position size ($1,000), which is $100. This is a 100% net profit since Bob only invested $100 in the first place. With a 10x leverage, Bob also increases his gain 10 times.

Nevertheless, things usually don’t go as we expect. Now let’s consider the adverse scenario where the price of BTC goes down to $18,000 - a 10% decrease. The value of Bob’s position now becomes $900, while that of the collateral (initial fund) reduces to $90. This means you make the lender lose $90 while you only lose $10.

Theoretically, BTC can go straight to $0 per token, meaning all of your $1,000 worth of BTC is gone. However, as a borrower, you only lose $100, whereas the one who supplies you such assets losses $900. Does not make sense, right?

As a result, the lender, or the third party in charge of the trade, puts out a tolerable level or liquidation price so that once it is reached, they will liquidate you and sell the borrowed assets to avoid further unintended losses.

How to calculate liquidation price

The liquidation price is calculated based on the leverage you use.

• Spot trading means trading assets at 1x leverage, so there is no probability of liquidation.
• For a 2x leverage, meaning you are doubling the order size, your order will be liquidated if the collateral value reduces (considering you are opening a long position) by half (50%).
• Similarly, for a 10x leverage order, you will be liquidated if the borrowed asset losses 10% in price. As for a 100x leverage, only a 1% loss is enough to liquidate your position.

How to avoid forced liquidation

Stop-loss

Using stop-loss is a simple yet efficient way to avoid forced liquidation. Stop-loss allows you to automatically close your position at a specific point, assumably before the liquidation price. Stop-loss is such a useful tool for traders to avoid losses during fluctuating market conditions, especially when you cannot look at price charts all the time.

Most centralized exchanges in crypto have supported this function.

Asset management

Asset management, or portfolio management, is a skill every crypto trader must know about. Asset management means you are actively managing and adjusting your portfolio to match market conditions. This includes buying and selling assets to control risks as well as maximize potential returns.

Asset management helps traders constantly evaluate and reevaluate their portfolios. It is extremely beneficial for avoiding liquidation since you are always aware of your position, thereby producing the best timing on when to open or close a leverage position.

Insurance fund

An insurance fund can be used to protect traders against excessive losses. It is a backup fund to cover users’ losses and avoid bankruptcy in case of sudden market crashes.

In crypto, insurance funds are created and maintained by mostly centralized exchanges like Bitmex, Binance, or OKX.

Reserve fund

A reserve fund is a separate amount of money that you keep for emergencies. Reserve funds can be used to improve your leverage position by additional depositing when it is close to the liquidation price. Increasing the amount of collateral will extend the liquidation point.

Liquidation vs. Margin call

Liquidation is different from margin call.

• Liquidation is the process of closing your leverage position and selling off your assets.
• Margin call is an action that requests you to deposit more funds to improve your leverage position in order to avoid liquidation. This is when the reserve fund comes into use.

FAQs

Who are liquidators?

In crypto, liquidators are the exchanges that you use for leverage trading, whether it is a CEX (centralized exchange) or DEX (decentralized exchange). Nevertheless, in reality, liquidators are actually mostly bots who work on their behalf behind the scenes.

What should we do after liquidation?

Here are a few tips on what you should do after being liquidated:

• Look back on the reason for the liquidation: Is it because of the market or of the quality of your own trade? Learn from your mistakes and understand the market better.
• Be patient, do not rush on another trade to attempt to break even. This often results in losing your temper and failing an additional trade.
• Improve your trading skills. Learn how to use methods like stop-loss to prevent liquidation from happening.

What is the liquidation fee?

Liquidation fee varies between different exchanges. For example, Crypto.com charges a flat 0.16% fee, while Binance provides a more complex structure.

Conclusion

Liquidation is the event of closing leverage positions and selling assets of leverage traders who can no longer maintain their leverage positions due to insufficient margin collateral. You can calculate the liquidation price based on the leverage you use. For a 10x leverage, a 10% change in price can lead to liquidation. For a 100x, this number becomes 1%.

You can use various methods to avoid liquidation: stop-loss, asset management, insurance fund, or reserve fund. The liquidation fee may vary depending on the exchange you are using.

Learn more: What is a Vampire Attack? How do Vampire Attacks work in Crypto?