What is Liquidation?

Preface

In the cryptocurrency market, many traders use leverage to amplify their profits, but high leverage trading also brings extremely high risks, like a double-edged sword, one of the most serious consequences of which is liquidation, meaning that when the account funds cannot meet the minimum margin required by the exchange, the system will automatically close the position to prevent further losses. Understanding the operation mechanism of liquidation, the potential risks it may bring, and how to prevent it is crucial knowledge that cannot be ignored for any trader using leverage.

What is liquidation?

Liquidation in simple terms, is a mechanism used by exchanges to control risk by forcibly settling a trader’s position when their margin is insufficient. This typically occurs in leveraged trading, when a sharp market price fluctuation causes the funds in the account to no longer support the existing position. In such cases, the system intervenes and executes a forced liquidation to ensure the safety of the exchange’s funds and prevent the risk of negative balances from expanding. For traders, this is often an unprepared liquidation, and once it happens, it means their funds are entirely wiped out, potentially even impacting the overall market price.

Mechanism of Forced Liquidation

The operation principle of leveraged trading is to amplify the trading volume through margin borrowing. In order to ensure that the borrowed funds will not incur losses due to market fluctuations, the exchange sets a minimum margin requirement. When the market price changes, causing the available funds in the account to fall below the maintenance margin threshold, the system will automatically trigger the liquidation mechanism, selling or buying the corresponding amount of assets at the market price to recover the borrowed funds as much as possible. In a highly volatile market, this mechanism may occur very quickly, and by the time investors realize it, their positions may already be fully liquidated.

Conditions for liquidation trigger

The conditions for forced liquidation vary slightly from one exchange to another, but the standard practice for most platforms is that when the account funds fall below the maintenance margin requirement, the system will automatically execute liquidation. Specifically, the conditions that affect forced liquidation include:

1. Leverage Ratio: The higher the leverage, the greater the risk of liquidation, as even a slight price fluctuation may result in insufficient margin.
2. Market Volatility: If the market experiences drastic changes in a short period of time, it may quickly push the margin down to the liquidation threshold.
3. Exchange rules: Different exchanges have different triggering conditions for liquidation, and some exchanges may liquidate in advance to ensure the safety of their own funds.

Therefore, in leveraged trading, it is important to not only pay attention to market trends but also fully understand the risk control mechanisms of the exchange being used to avoid being liquidated without preparation.

Risk of liquidation

The risks brought by liquidation are far more than just the account funds going to zero, but may also lead investors to suffer greater losses due to market fluctuations and liquidity issues.

1. Unable to close position at the desired price: During intense market fluctuations, forced liquidation by the exchange may result in traders’ assets being sold cheaply, leading to more severe losses.

2. Slippage Risk: Liquidation may encounter slippage, which is the deviation between the execution price and the expected price, especially when market depth is insufficient, the liquidation price may be far below investors’ psychological expectations.

(Slippage: In the trading process, due to market fluctuations or insufficient liquidity, there is a deviation between the actual transaction price and the expected order price.)

3. Market Chain Reaction: When a large number of traders are liquidated at the same time, the market may further fluctuate dramatically, leading to more people being liquidated, forming a ‘domino effect’ and intensifying market panic.

These risks all indicate that leveraged trading is not suitable for everyone, traders must have a full risk management awareness to reduce the impact of liquidation.

How to avoid liquidation?

Although liquidation is a risk that cannot be completely avoided in leveraged trading, the probability of its occurrence can be significantly reduced through reasonable trading strategies.

1. Set leverage ratio reasonably: Choosing a lower leverage ratio may not yield extremely high returns, but it can effectively reduce the risk of liquidation.
2. Margin top-up: If the market fluctuates significantly, you can timely add margin to ensure the minimum funds required to maintain the position.
3. Set stop-loss order: Set the stop-loss point in advance. When the price reaches the preset range, the position will be closed automatically to avoid larger losses.
4. Choose trading pairs with good liquidity: Coins with large trading volume usually have better market depth, making it less likely to encounter extreme slippage even in the event of liquidation.

Margin trading is a high-risk, high-reward investment method. Traders should set appropriate trading strategies according to their own risk tolerance, ensure proper fund management, and proceed steadily in the market fluctuations.

The Impact of Liquidation on the Market

Forced liquidation not only affects the assets of individual traders, but when a large number of forced liquidations occur in the market, it can trigger a chain reaction, causing significant price fluctuations. For example, in exchanges with high leverage ratios, when prices drop rapidly, the positions of many investors may be liquidated simultaneously, creating a cascading effect of forced liquidations. This can ultimately lead the market into a vicious cycle, potentially impacting the overall stability of the cryptocurrency market.

Summary

Liquidation is a risk that cannot be ignored in leveraged trading, which may instantly wipe out all positions of traders, even affecting market stability. Through reasonable leverage settings, risk management strategies, and accurate market trend analysis, traders can still effectively reduce such risks. Although leveraged trading can bring high returns, it is more important to maintain a stable trading mindset, prudently manage funds, in order to survive in the high-risk market environment in the long term.