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Crypto Glossary/Liquidation

Liquidation

Dive into the world of futures trading & liquidation - learn risks, rewards, and strategies. Boost your crypto trading skills with Coin360.

TLDR - Liquidation in Futures Trading

In the high-stakes, rapid-fire world of futures trading, understanding liquidation is crucial for managing risks, especially when you're swinging around positions like Thor's hammer with leverage. Liquidation is like the referee in a boxing match, stepping in when a trader's account can't take anymore blows from the market's heavy punches. It prevents traders from spiraling into financial oblivion when the tides of the market turn against their positions. Whether you're a trading rookie or an experienced market wolf, a solid grasp on liquidation will serve you well. In this guide, we'll delve into:

  • Core Concept of Liquidation: Risk management in leveraged trading.
  • Partial vs Total Liquidation: Two liquidation types explained.
  • Risks and Rewards of Liquidation: Liquidation's impact on trading.
  • Liquidation's Market Influence: How liquidation affects market visibility.
  • Conclusion: Summing up key liquidation insights.
  • FAQs on Liquidation: Answering your crucial questions.

I. Futures Trading

Futures trading, where you're making bets on the future price of assets, can be a profitable venture when done right. It's like fantasy football for finance aficionados, except you're playing with actual money and not just bragging rights. With futures, you're agreeing to buy or sell an asset at a specific date in the future, hence the name.

Leverage is the secret sauce that makes futures trading spicy. It's like your over-enthusiastic gym buddy who always pushes you to lift more weight. Leverage allows you to control large positions by only coughing up a fraction of the total value, known as the initial margin. While leverage can amplify profits, it can also magnify losses if the market decides to throw a curveball your way. Remember, with great power comes great responsibility!


II. Understanding Liquidation

Think of liquidation as a financial fire extinguisher. It's a tool used by exchanges to put out the fires in your account before they consume all your capital. If your leveraged position starts to bleed money and doesn't have enough funds to remain open, the exchange will automatically and forcibly close your position. This process is like an auto-pilot risk manager that swoops in to protect you from biting off more losses than you can chew.

Liquidation can be a bitter pill to swallow. The extent of the liquidation loss depends on your initial margin and how far prices have fallen. It's kind of like falling off a cliff: the higher you are (more leverage used), the harder you fall (greater the potential loss).


III. Types of Liquidation

Liquidation can come in two flavors: partial or total. A partial liquidation is like a jab to the face. It's painful, but you're still standing. The system reduces the corresponding tier of an adjustment factor, preventing all positions from being liquidated at once. It's a strategic move designed to give you a fighting chance to bounce back.

Total liquidation, on the other hand, is a knockout punch. Your entire position is closed when there's no initial margin left, resulting in the loss of all invested assets. It's the financial equivalent of getting thrown out of the ring.


IV. How Liquidation Occurs

The path to liquidation starts when you're unable to meet the margin requirements. This is like failing to pay the cover charge at a fancy club - if you can't afford it, you're not getting in. If the value of your margin account falls below the margin, the bouncer (exchange) will start the liquidation process.

Example of a Liquidation event

Consider Charlie and Dana, who both entered opposing positions in ETH/USDT perpetual futures worth 10 ETH with 10x leverage. Both have wallet balances of 4,000 USDT each. The table shows the details of their respective positions.

PositionEntry PriceNotional ValueInitial MarginMaintenance MarginLiquidation Price
CharlieLong$2,00010%1%$1,800
DanaShort$2,00010%1%$2,200
Table - Position details of Charlie and Dana

Suppose there's a 15% drop in ETH/USDT perpetual prices to $1,700. In this situation, Charlie faces a loss of $3,000 in his long trade, while Dana profits $3,000 on her short trade. The subsequent events unfold as follows:

  • Charlie's margin is depleted, triggering a liquidation event.
  • The price at which the margin falls to zero, $1,800 for Charlie, is known as the liquidation price.
  • The exchange immediately liquidates Charlie's position at $1,800 to prevent Charlie's account from going into negative equity.

In rapidly moving markets, ensuring that losing positions are liquidated exactly at their liquidation price is a challenge. Moreover, liquidating beyond the bankruptcy price would mean that Dana reaps fewer profits, and Charlie suffers greater losses.

To avoid this, exchanges aim to liquidate the losing positions at a price better than the liquidation price.

In the event an exchange can't liquidate positions before a trader reaches negative equity, they employ the following methods to cover the losses of bankrupt positions:

  • Insurance Fund: This fund is maintained by the exchange to guarantee that profitable traders receive their profits in full and offset any additional losses incurred by a bankrupt trader.
  • Auto-deleverage liquidations (ADLs): Here, the exchange selects opposing traders in order of leverage and profitability. Positions from these traders are automatically liquidated to cover the losing trader’s position.

V. Margin Call

Before you hit the liquidation threshold, you'll get a wake-up call known as a margin call. This is the exchange's way of saying, "Hey, you're running out of funds! Either add more money, close your position, or brace yourself for liquidation." It's a last-minute lifeline that gives you a chance to salvage your sinking ship.


Conclusion

Understanding liquidation in futures trading is like learning to handle a sports car. It's exhilarating, complex, and fraught with risks. Leverage can turbo-charge your gains, but it can also drive you straight into a wall if you're not careful. That's where liquidation steps in, protecting you from financial wipeouts and keeping your account from crashing and burning.

Just like how you wouldn't hit the road without understanding traffic rules, you shouldn't dive into futures trading without getting a handle on liquidation.


FAQ about Liquidation

1. What is liquidation in futures? 

Liquidation in futures trading is the process where the exchange forcibly closes a trader's position to prevent their accounts from going into negative equity. This generally happens when a position doesn't have enough funds to maintain the margin requirements for a leveraged trade.

2. What does liquidation price mean in futures?

 In futures trading, the liquidation price is the market price at which a trader's position will be automatically closed or liquidated by the exchange to prevent further losses. It is calculated based on the position size, the initial margin, and the leverage used. It is a crucial metric for traders to manage their risks and prevent their accounts from being wiped out.

3. How do you avoid liquidation in futures? 

Avoiding liquidation in futures trading primarily revolves around effective risk management. Here are a few strategies:

  • Maintain a healthy margin balance: Always have enough funds in your account to withstand market volatility.
  • Use appropriate leverage: High leverage can lead to significant profits but can also result in substantial losses. Use leverage judiciously.
  • Use stop-loss orders: These can limit your potential losses by automatically closing your position when the market price reaches a certain level.
  • Stay informed: Keep track of market trends and news that could impact the price of the assets you're trading.

4. Can I get liquidated with 1x leverage? 

When trading at 1x leverage, which is essentially spot trading, the risk of liquidation is non-existent. This is because you're only trading with the capital you already possess, not borrowing any additional funds from the exchange. Thus, the value of your assets can decrease with the market, but a liquidation event - where the exchange forcibly closes your positions - won't occur because you're not in debt to the exchange. However, it's crucial to remember that this doesn't eliminate the risk of loss. If the asset's value decreases significantly, your investment can still shrink accordingly.

5. Is liquidation good or bad? 

Whether liquidation is seen as good or bad can depend on perspective. From a trader's perspective, liquidation is typically seen as bad because it results in a loss of funds. However, from a risk management perspective, liquidation can be seen as a necessary tool. It serves as a safety net to prevent traders from incurring losses that exceed their account balance. Like a safety valve, it helps maintain the overall health of the financial system.

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