What Does Liquidation Mean and How to Avoid It?
The crypto market’s high volatility means liquidations are a common occurrence.
Bitcoin and other cryptocurrencies are renowned for being high-risk investments prone to extreme price swings. But while this volatility makes them a concern for regulators, it also presents an opportunity for investors to generate significant profits, particularly when compared to traditional asset classes like stocks and commodities. Over 2020, amid the coronavirus outbreak, bitcoin ended the year up 160% versus the S&P 500 at 14% and gold up 22%.
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 futures. Derivatives are contracts based on the price of an underlying asset and allow people to bet on the asset’s future price. Crypto derivatives first appeared in 2011 and have gathered huge momentum in more recent years, especially among gung-ho retail investors looking to get the most out of their trading strategies.
With margin trading, traders can increase their earning potential by using borrowed funds from a cryptocurrency exchange. Binance, Huobi and Bitmex are some of the leading examples of centralized crypto exchanges that allow customers to trade on margin.
But there’s something very important to note here. While borrowing funds to increase your trade positions can amplify any potential gains, you can also lose your invested capital just as easily, making this type of trading a two-edged sword.
What is margin trading?
Margin trading involves increasing the amount of money you have to trade with by borrowing third-party funds. Think of it as borrowing money from a stranger to buy bitcoin or another cryptocurrency. But in this case, you are borrowing from a crypto exchange. This allows investors to increase the size of their trading positions, also known as “leverage.”
Naturally, a stranger would not lend you money to trade for free. Similarly, in margin trading, the exchange will require you to put up an amount of crypto or fiat as collateral – known as an “initial margin” – in order to open a trading position. This initial margin is like an insurance fund for the exchange in case the trade goes against the borrower.
It is also worth mentioning that the amount of money you can borrow from an exchange relative to your initial margin is determined by the leverage. For example, if you use a 5x leverage on an initial margin of $100, you will be taking a $400 loan to increase your trading position from $100 to $500.
Each trade has the potential to make or lose more money depending on the size of the leverage. For instance, using the 5x leverage example above, if the price of an asset rises by 10%, you will make a profit of $50 on your $500 trading position, which represents a 50% profit relative to your initial $100 margin. You could then repay the $400 loan you took out and keep $150 for yourself ($50 profit + $100 initial margin.)
However, if the value of the cryptocurrency you’re trading drops by 10%, you would have lost $50 from your initial margin (50% loss.)
There is a simple formula to calculate your potential profits/losses when using leverage.
Profit or Loss = (Initial Margin) x (% price movement) x (leverage)
For clarity, use “plus” to represent positive price movements and “minus” for negative price movements. In general, remember that leverage is how much your initial margin can gain OR lose. Ensure you keep your potential losses to manageable levels.
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 (fails to have sufficient funds to keep the trade open.) Liquidation 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:
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 (bought by another trader.)
The primary purpose of a stop loss is to limit potential losses. To put things in perspective, let’s consider two scenarios.
Scenario 1: A trader has $5,000 in his account but decides to use an initial margin of $100 and leverage of 10x to create a position of $1,000. He places a stop loss at 2.5% from his entry position. In this instance, the trader could potentially lose $25 in this trade, which is a mere 0.5% of his entire account size.
If the trader does not use a stop loss, his position will be liquidated if there is a 10% drop in the price of the asset. Remember the liquidation formula above.
Scenario 2: Another trader has $5,000 in his trading account but uses an initial margin of $2,500 and a 3x leverage to create a position of $7,500. By placing a stop loss at 2.5% away from his entry position, the trader could lose $187.5 in this trade, a 3.75% loss from their account.
The lesson here is that while using higher leverage is typically considered very risky, this factor becomes very important if your position size is too large, as seen in the second scenario. As a rule of thumb, try to keep your losses per trade at less than 1.5% of your entire account size.
Where to set a stop loss
When it comes to margin trading, risk management is arguably the most important lesson. Your primary goal should be to keep losses at a minimum level even before thinking about profits. No trading model is infallible. Therefore, you must deploy mechanisms to help you survive when the market doesn’t go as expected.
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 (provided it’s not so low you’d stand to be liquidated before it triggered).
Secondly, you should manage your trading size and the associated risk. 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. BitMEX, for example, only allows traders to hold BTC as initial margin. This means if bitcoin’s price falls, so too does the amount of funds held in collateral resulting in faster liquidations.
Due to the risk associated with leverage trading, some exchanges have moved to lower the limit traders can access. Both Binance and FTX are among the leading centralized crypto exchanges to slash leverage limits from 100x to 20x.Source