Liquidation In Crypto: Definition, Methods, and Examples

In trading, the term liquidation refers to the process of closing a cryptocurrency position in order to minimize losses in unforeseen market conditions.

On a crypto exchange, liquidation is compulsory.

It occurs when an open position loses all or part of the trader's initial margin capital.

Compulsory closure occurs in situations where the user's account does not have sufficient funds to maintain open trades. This can happen, for example, when the value of the underlying asset falls sharply.

In such cases, the exchange automatically closes all positions, resulting in the loss of the investor's funds.

In certain cases, liquidation can lead to the complete loss of the investment. The level of risk is influenced by the size of the initial margin, the extent of the decline in the price of the underlying asset, and other factors.Depending on the situation, there are two types of liquidation:

1. Partial. The position is closed at an early stage, which reduces leverage.

2. Full. The position is closed completely, and leverage is reset to zero.

Cryptocurrency liquidation can occur in various types of markets:

1. Spot

2. Margin

3. Futures

The term liquidation is most widely used among traders working with futures.

A futures contract is a contract whereby the buyer undertakes to purchase and the seller undertakes to sell a specific asset within a specified period and on pre-agreed terms.

How does liquidation occur in the cryptocurrency market?

The liquidation process in the cryptocurrency market occurs as follows. If a trader's open position no longer meets the margin requirements, the exchange automatically closes it. This occurs when the user's margin falls below the level set by the trading platform.

The margin is the amount required by the exchange to maintain the position and is calculated as a percentage of the total transaction volume. The liquidation percentage is determined by the formula 100 divided by the leverage.

For example, with a leverage of 10x, the liquidation percentage will be 10%. This indicator is critically important, and traders must monitor it and understand that if the price of an asset changes by the liquidation percentage, the position will be forcibly closed.

Consequently, increasing leverage automatically increases the risk of liquidation.

In some countries, cryptocurrency exchanges are prohibited from offering leveraged trading. This is done to protect inexperienced market participants from losing capital. An example of such a country is the United Kingdom.

In addition to the liquidation price, the concept of bankruptcy price is used in trading. This is the level of asset value at which the margin is completely wiped out. To avoid a total loss of funds, the exchange uses the liquidation price to forcibly close the position.

In other words, margin serves as collateral for the trader's transactions and insurance for the exchange in case of user losses.

When a margin position reaches the liquidation threshold, the platform notifies the trader with a Margin Call message.

Source: TradingViewUpon receiving a notification from the exchange that the liquidation threshold has been reached, the trader can take the following actions:

1. Add the required margin amount to restore the leverage to its initial level.

2. Take no action, in which case the exchange will automatically close the position by performing the liquidation procedure.

In accordance with the example given, the trader's own capital is $100 and the leverage is 10x. If the price of the underlying asset falls by 10%, the total value of the position will decrease to $900 ($1000 − 10%). This means that the trader will lose all of their own capital of $100.

In trading, cryptocurrency liquidation is divided into two types:

1. Ordinary

2. Forced

The classification depends on who performs the procedure. In the first case, the liquidation is initiated by the trader themselves, in the second case, the liquidation is performed by a broker or cryptocurrency exchange.

Liquidation is the conversion of one asset into another, most often into fiat money or stablecoins, depending on the platform's rules.

The main difference between the types of liquidation is only who initiates the process.

How to avoid liquidation

1. Use stop losses. To reduce the risk of liquidation, always set Stop-Loss orders on open positions. This will automatically close the trade when a certain level of loss is reached. Various types of orders on the exchange, such as limit and market orders, help you manage your positions flexibly and respond to market fluctuations in a timely manner.

This approach protects your capital and prevents unexpected losses in the event of sharp price changes.

2. Monitor your position. Regularly check your margin level and the status of your trades. Do not allow your margin to fall to a critically low level. If necessary, replenish your account or close some of your positions to stay in the safe zone and avoid forced closure of your position by the exchange. In some cases, you can convert cryptocurrency into more stable assets to reduce risk and maintain sufficient margin.

Many exchanges also provide liquidation calculators that allow you to calculate the liquidation price in advance and manage risk more effectively.

3. Reduce leverage. Using high leverage increases the risk of liquidation. Use moderate leverage, especially in volatile markets.

Low leverage gives you more room for price fluctuations without the threat of forced position closure and allows you to better control risks.

4. Consider current prices. Monitor the market and analyze current prices to understand the direction of asset movements.

Awareness of market trends helps you make more informed decisions when opening and closing positions, reducing the likelihood of liquidation.

Example of a BTC liquidation heat map

Heat maps are an important tool for traders, allowing them to identify areas of the highest liquidations and understand where market participants are losing positions during sharp price fluctuations.

Maps of this type show the levels at which significant liquidations occurred, especially among traders using margin trading on crypto exchanges.

The screenshot below shows the following:

1. The color scale on the left, from green to purple, reflects the intensity of liquidations. Green areas indicate high liquidation volumes, while purple areas indicate low activity.

2. X-axis. Shows the timeline, demonstrating price changes by date and time.

3. Y-axis. Displays the range of Bitcoin prices at the time of liquidations.

Source: Coinglass

In conclusion on Liquidation

Liquidation is one of the unfavorable aspects of trading on the exchange. It is impossible to completely insure yourself against losses, so traders must plan their actions in advance and be prepared for unfavorable developments in the market.

You can reduce the risk of liquidation or mitigate its consequences by controlling the margin ratio and leverage, trying to reduce its value as much as possible.

In addition, it is recommended to use stop-loss orders, which help limit losses and minimize the risk of forced position closure.Sign up and get access to free (for now) 0 to educated investor crypto education crash course.  Telegram | Discord | Twitter (X) | Medium | Instagram 

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Cryptocurrency market operates 24/7/365 without interruptions. Before investing, always do your own research and evaluate risks. Nothing from the aforementioned in this article constitutes financial advice or investment recommendation. Content provided «as is», all claims are verified with third-parties and relevant in-house and external experts. Use of this content for AI training purposes is strictly prohibited.