Crypto Liquidation Explained and Tips
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Volatility makes crypto become so attractive to investors. With leveraging, you may maximize the potential gain, as well as the potential loss.
Crypto Liquidation is one of the most hated situations faced by investors who carry out leveraging. Don’t miss this article to teach you what to do when Crypto Liquidation happens.
What is Crypto Liquidation?
Liquidation means the ability to turn an asset into cash. But in crypto trading, when the price of a crypto asset is dropping, a trader’s leveraged position is forced to close, due to the margin not being enough to cover the loss. If the trader can’t meet the margin call, the exchange will close the position automatically. That's called liquidation.
What is Crypto Margin Trading?
Crypto margin trading means borrowing money from crypto exchanges to increase the trading volume. That also means leverage. With leverage, you can open a larger position with a lower capital so that the potential gain may be increased. On the other hand, it carries more risk. If the market is not favorable to you, it will increase the risk of liquidation.
If you want to open a margin trading position, exchanges usually request you to put an amount of initial margin like crypto assets or fiat as collateral. It aims at offsetting the risk borne by the lender if there is a loss in trading.
How does Crypto Liquidation Happen?
Assuming the leverage ratio is 10x, you can buy a $10,000 crypto asset for only $1,000. If the price increases by 5%, you will gain a $500 profit, which is 50% of return. If the price of the asset dropped 5%, you will suffer a loss of $500, which is also 50%. If the price decreases by 10%, which is $1,000, the exchange will close the position automatically and liquidation happens.
Before liquidation, you will face a margin call, asking you to put up more margin. If the price keeps dropping, you will have to continue to put up a margin to keep the position open. Otherwise, the position will be closed. If you open a position with a 20x leverage, only a 5% drop in price will lead to liquidation.
What is partial and total liquidation?
There are two types of liquidation, including both total and partial.
Total liquidation: When all the initial margin is used, the position will be forced to close.
Partial liquidation: The position is closed at an early stage before all the initial margin is used. It aims to prevent the loss of the trader. It’s up to the agreement between traders and exchanges.
How to Avoid Crypto Liquidation?
It’s impossible to completely eliminate the risk of liquidation. The higher the leverage ratio, the higher the risk. You may apply different strategies to reduce risk and minimize the loss.
Stop loss strategy
Setting up a specific price to close the position automatically in order to minimize the loss.
Set up an insurance pool
Each crypto exchange should set up a reserve pool to cover the contract loss. If the liquidation price is higher than the initial margin, the insurance pool will cover the loss.
From each leverage trading, the crypto exchange may reserve a certain amount of service charge in the insurance pool to reduce the loss in liquidation.
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Disclaimer:
This article should not be taken as the basis for making investment decisions. Trading digital assets involve significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary.
