What is liquidation in crypto? How do I avoid it?

Liquidation is one of the biggest risks for crypto traders who use margin or leverage. Liquidation in crypto refers to the forced closure of a transaction or position, often resulting in margin exhaustion. The concept may seem complex, but we will explain it in simple terms.

In this article, we will explore what crypto liquidation is, how it occurs, and, most importantly, how you can avoid it. By understanding margin levels, liquidation prices, and risk management strategies, you will learn how to trade crypto more safely and sustainably. Let’s begin!

What is margin trading?

Margin trading involves borrowing funds from an exchange to open a larger position than you could with just your own money. For example, if Bitcoin is trading at $70,000, with 2x leverage, you could buy $140,000 worth using just $70,000 of collateral.

Crypto exchanges set both an initial margin and a maintenance margin level. The initial margin is how much you need to deposit to open the trade. Maintenance margin is the lowest balance your account can fall to before liquidation. If it dips below that point, the exchange forcefully closes the position.

What margin level triggers liquidation?

Every crypto exchange sets its own margin requirements, but most use a maintenance margin level of around 20–30% as the trigger for crypto liquidation. For example, if an exchange has a 25% maintenance margin level:

• When the value of your collateral plus open positions drops below 25% of the position's notional value, it reaches the liquidation point.
• The exchange will start closing out positions, typically in tranches, to recoup losses until the account is brought back above the 25% margin level.
• It is crucial to watch your account balance and maintain sufficient collateral above maintenance levels to avoid unwanted liquidation in crypto.

What is an example of crypto liquidation?

Let's imagine an example of a cryptocurrency exchange with these details:

• You open a leveraged long position worth $10,000 using 2X leverage.
• The exchange requires a 30% maintenance margin.
• The current Bitcoin price is $70,000.

If the price of Bitcoin suddenly drops to $63,000, the value of your position drops to $9,000 (-10%). But since you borrowed funds for leverage, your account balance would now be below the 30% maintenance margin.

The exchange would forcibly sell or liquidate your position to try and regain the lost collateral. Any remaining funds after closing the position would be kept by the exchange as payment for the crypto loan.

This shows why liquidations often happen very quickly during volatile market crashes, or "flash crashes," leaving little time for crypto traders to react. Strong risk management is key to avoiding unexpected liquidations.

What causes liquidation in crypto?

There are a few main triggers that can cause your crypto positions to get liquidated:

• Extreme market volatility. Crypto markets are highly volatile, so rapid price swings in either direction increase crypto liquidation risk.
• Using high leverage. The more leverage employed, the smaller the market move needed to breach maintenance margins. Leverage acts as a double-edged sword.
• Poor risk management. Factors like inadequate stop-losses, choosing high-risk assets, and not accounting for slippage can all increase the odds of an untimely liquidation.
• Exchange system issues. In rare cases, liquidation in crypto may occur due to unplanned exchange downtime or other technical problems disrupting margin functions.
• Stop-hunting algorithms. Some traders hypothesize that market makers may push prices towards stopping traders' liquidation points during volatile periods. Being aware of such liquidation catalysts helps formulate prudent risk controls.

What is the liquidation process for cryptocurrency?

Once your account balance breaches the maintenance margin, exchanges typically follow a standard process for liquidating positions:

• The exchange will try contacting you via email or app notifications to deposit more funds.
• If there is no response after a grace period, forced liquidation begins. This usually entails selling positions in tranches to gradually cover losses.
• Starting with the smallest positions first, sell orders are placed at current market rates to repay the borrowed margin and cover crypto trading losses.
• Crypto liquidations continue to close out more positions until the account value reaches the maintenance level again.
• Any remaining funds after closing all positions belong to the exchange as a settlement for the loan. Traders lose all control over their leveraged positions. It's a steep process, so avoiding it through sound risk practices is essential for traders.

What is the difference between long liquidation and short liquidation?

The crypto liquidation process is effectively the same, but long and short positions face liquidation under opposite market conditions.

Here are the details of each liquidation process:

Long liquidation

• Going long means betting the price will rise.
• If the market moves against your long, dropping the position value below the maintenance margin, it faces liquidation.

Short liquidation

• Shorting means anticipating a price drop.
• If the market moves in the opposite direction of your short, increasing the position value above the maintenance margin, it faces liquidation.

In both cases, liquidation in crypto aims to settle any losses from the leveraged position and bring the account back to deposit requirements. Traders need to consider how liquidations may occur differently for long vs. short trades.

Key steps to minimize crypto liquidation

By following some best practices, traders can significantly reduce their crypto liquidation risk.

• Use lower leverage, like 2x to 5x, for less volatility-induced margin calls. High leverage, like 100x, should be avoided.
• Place contingent stop-losses to automatically close positions before liquidation points. Factor in market slippage.
• Diversify funds across multiple assets rather than concentrating on single crypto coins or crypto tokens.
• Continuously monitor positions and be ready to add collateral or close trades manually if needed.
• Trade established assets with sufficient liquidity rather than small, low-cap coins prone to volatile movements.
• Understand that liquidation can occur overnight due to gaps, so secure an adequate surplus margin for positions held through Asian or weekend sessions.
• Set aside a portion of each profit as an offsetting liquidation insurance fund to deploy if prices move against you.

Disciplined risk practices are key to making the most of leveraged crypto opportunities while avoiding stressful auto-liquidations. Staying firmly in control of one's risk exposure is advisable for all margin traders.

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The bottom line

Crypto liquidation happens when leveraged positions are forcibly closed by crypto exchanges due to losses breaching maintenance margins. While margin trading enables larger position sizes, it simultaneously increases the risk of unwelcome liquidations during market volatility.

By comprehending liquidation triggers, practicing sound risk management with crypto trading strategies like contingent stops and diversity, and maintaining a sufficient collateral buffer, traders can stay in the driver's seat of their leveraged crypto endeavors.

Implementing methods to avoid unexpected forced closures will result in a more enjoyable and, importantly, far more profitable trading experience overall. Using a secure digital asset is also another key point, and EURK EUR stablecoin offers many benefits to its users.

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