All You Need to Know About Trading Liquidation
At some point in your cryptocurrency futures trading, you are bound to experience a liquidation event where your position is forcibly closed. Let us look more closely at liquidation examples and ways to avoid them in this article from CoinMarketSIG .
An overview of core principles of position liquidation during margin trading in crypto exchanges. Thanks to margin trading, a trader can use the cryptocurrency borrowed from the exchange. Naturally, nobody lends money for nothing — an exchange client gives a pledge (Initial Margin) for capital management when opening a trading position. In order to protect itself from losing money, each trading platform has the right to start the process of liquidating.
What is digital currency liquidation?
Liquidation is the process of closing a trader’s long position or shorts due to the loss of all or almost the trader’s entire initial margin. In most exchanges, if the market price reaches the price of liquidation of the traders, their position is closed automatically.
Long (buy) positions have a liquidation price lower than the original entry price, and the opposite is true for short (sell) positions.
Contracts in Phemex exchange can be purchased with high leverages. To be able to keep these positions open, you must keep a percentage of the value of the position in an exchange office, known as the Maintenance Margin.
If you cannot meet the conditions of your guarantee, your positions will be liquidated and you will lose your initial margin. Phemex Exchange uses the Fair Price Marking mechanism to help users prevent forced liquidations due to lack of liquidity or manipulation.
Risk limiters can also be used for larger positions that require more margins. This extra margin allows our liquidation system to perform better in large positions that would otherwise be difficult to close securely. If the liquidation process is activated, our system will try to close all open orders related to that contract to provide enough money to keep the trading position open.
How to calculate the refining price?
When you open a leveraged trading position, its liquidity price is determined automatically. If the price of digital currency crosses this line, the position is automatically dissolved.
The liquidation price depends on the position of the trader, the leverage and the amount of funds remaining in his account. No need to manually calculate the sign — the money changer calculates everything for you. For example, in the case of BitMEX or Binance, you can use a calculator to calculate the liquidation price.
Example: You deposit 0.01 bitcoins and open a bitcoin order with 100 times your leverage. There is a problem and the price of Bitcoin is in the opposite direction to the price that you only need 1%. Because of this move, your position with 0.01 BTC, ie your margin value, is not profitable. Slightly more and the exchange will lose, so the liquidation algorithm automatically closes the transaction.
Keep in mind that the higher the leverage, the lower the percentage change in price will lead to liquidation. This means that if you open a trade with 50 times the leverage, a price move of only 2% in the opposite direction will lead to liquidation.
It is recommended not to use the lever more than 10 times and beginners should not try to trade with a margin higher than 2 times.
In cases where the stock exchange is not able to liquidate the positions before the trader reaches a negative level, the following methods are used to cover the losses of bankrupt positions:
- Insurance Fund: A fund maintained by an exchange office to allow traders to make a full profit and ensure that the bankrupt trader does not incur unnecessary losses.
- “Social losses” system: This method distributes the losses of bankrupt positions among all profitable traders.
- Automatic Lever Liquidation (ADL): With ADL, the exchange selects traders’ market positions based on profit and leverage and automatically closes their positions to cover other positions.
Three tips to prevent liquidation
There are ways to prevent liquidation in a less general sense. Traders should keep in mind that losses in trades are always possible, but liquidation should not always happen. There are tools available to prevent this from happening, and there are smarter trading strategies such as margin monitoring or the use of lower leverage.
Use Stop Loss
First, the clearest answer to avoiding liquidation is simply to use a loss limit higher than the price of liquidation. Stop Loss is a trading tool offered by most exchanges, which allows traders to set a selling price automatically if the asset price falls below or above this predetermined price. By trading stop losses with the liquidation calculator, traders can protect their funds from being lost in general and in particular against liquidation.
Although you may still lose some capital, the stop loss tool protects you from losing everything in the transaction and paying the liquidation fee. Besides, who wants to lose and be fined for it? You can prevent this from happening by using Stop Loss.
Use less leverage
Leverage has a significant impact on the life of the transaction. While using large amounts of leverage may be tempting, lower amounts of leverage will always be a safer route. Excessive use of leverage can actually lead to great victories. However, it can also increase your losses.
As shown above, a high amount of leverage can hurt a trader, even when a small price change occurs. Using a lower lever will help you navigate smoothly and safely in the volatile crypto market.
Monitor the margin ratio
Another option traders can implement is margin ratio monitoring. When the margin ratio reaches 100%, the position dissolves. To avoid this result, traders can add more margins to their trade and reduce their position (return leverage). This method is similar to maintaining a position when it is close to 100% (when the trade is moving in the wrong direction).
Adding more margins or reducing leverage is similar to starting with less leverage in the first place. The difference is that maintaining a certain margin ratio can be done over longer periods and is a dynamic solution.
Liquidation is a scary word that traders prefer to avoid if possible. The good news is that traders have a number of trading tools and strategies that they can implement to prevent them from dissolving. From stop loss to liquidation calculators, proper use of leverage and monitoring of margin ratios, traders have multiple resources to prevent liquidation.
Liquidation is just one of the things that traders need to be aware of when learning how to trade. If you think, you might want to learn more about trading, Binance offers everything a trader might need to do responsible trading. In addition to this article, Binance Academy is always available as a resource for best trading practices, trading terms and trading tools. Discover the Academy’s ultimate guide to trading in Binance futures.
Beyond that, Binance offers traders extremely competitive rates, commissions and options. More information on margins and futures can always be found at Binance Academy, and getting started with Binance is easy.