What Is Liquidation and How to Avoid It

We added Binance Futures Coin-M at the end of last month. Trading crypto futures, you will face liquidation sooner or later. For newbies, such an event is confusing and extremely disappointing. Given the high volatility and high leverage, an open position can be liquidated suddenly, without any warning. When does liquidation happen? Сan an ordinary trader prevent it? That's what we find out today.

Definition

For starters, liquidation is a pretty horrible thing for any trader. In the futures market, it happens because crypto fans borrow additional funds to carry out major transactions. Since some platforms offer leverage up to 100x, traders are given the opportunity to raise capital 100 times. Obviously, there's always the dark side of it. A dramatic increase in the asset price can cancel a position, i.e. liquidate it.  Loss-making positions are forcibly closed to avoid a negative balance on the trader's account. The speed of the process depends on the leverage size. If it is small, you're safe from liquidation (provided that there is a slight correction in the market). But high leverage can quickly drain the initial investment of traders.

We know what you're thinking: will there be a liquidation if the exchange works flawlessly? Is closing positions typical for time-tested platforms? The answer, by the way, is yes.

When Does Liquidation Begin?

The compulsory liquidation process starts when the investor/ trader ceases to meet the margin requirements for positions with leverage. Imagine that you want to open a long BTC/BUSD position for $100. You have used the 20x leverage and now the value of your position is $2,000. If the digital gold price drops by 5%, it will completely destroy the initial margin of $100. The margin call requirements for saving the transaction will not be met, so the position is threatened with liquidation.

What to Do?

The good news is that liquidation can be prevented by following three simple rules:

  • Use Stop Loss 

A great way to avoid closing a position is to set a stop loss above the liquidation price. The use of this order is an important element of risk management (check out the professional judgment of risk management in our article). That is why any (sensible) books, webinars, manuals emphasize its importance in crypto trading. Of course, you can lose some of your money, but the limit order will insure you against the loss of all capital and the liquidation commission. Instructions for using this tool are waiting for you here.

  • Decrease Your Leverage

Liquidation is a by-product of leverage. The latter plays a huge role in the transaction duration. High leverage promises great prospects, but a low one is always safer. Large leverage can turn into both profit and serious losses. It can harm the trader even with a small change in price. Low leverage is the best option for trading in a volatile crypto market. 

  • Monitor the Margin Ratio

If it reaches 100%, the position will be canceled. To ensure that that does not happen, crypto lovers should add margin and downsize the position (by decreasing the leverage). This method is similar to saving a position when the ratio approaches 100% (if the transaction continues to move in a losing direction).

An additional margin or a decreased leverage is similar to starting with smaller leverage. The main difference is that it is possible to maintain a certain margin ratio for a longer period of time. Plus, this is a more effective solution.

Bottom Line

The market doesn't owe you anything. It doesn't care what you want. You have to take charge of your own capital. Efficient preparation for trading taking into account liquidation will reduce losses and minimize the probability of forced closing of positions. Use stop losses, decrease leverage, and monitor the margin ratio. Do you want more useful tips for traders? Kindly follow us on: Twitter, Facebook, or Telegram.