When do exchanges liquidate positions: why traders lose money during sharp crypto price swings

Sharp movements in the price of Bitcoin and other digital assets are often accompanied by mass liquidations of trading positions worth hundreds of millions of dollars. This phenomenon is common in markets where traders actively use leverage to increase their trading positions. Understanding how liquidations work on exchanges helps minimize risks and avoid capital loss.

How Margin Trading Works and Why It’s Dangerous

Modern cryptocurrency platforms provide traders with tools to increase the size of their trades through borrowed funds. These tools include margin trading, perpetual contracts (perpetual swaps), and cryptocurrency futures. The first derivatives on crypto assets appeared in 2011, but widespread adoption among retail investors happened later, when major crypto exchanges started offering these products with user-friendly interfaces.

In margin trading, a trader deposits a certain amount of their own funds (this is called “initial margin”) and may borrow additional funds from the exchange to increase the position size. The amount of borrowed money is determined by the leverage. For example, with 5x leverage, a trader can control a position five times larger than their initial deposit.

The appeal of this approach is clear: if the asset’s price increases by 10%, profit is calculated not from the small initial investment, but from the entire enlarged position. However, this double-edged sword means losses are also multiplied by the leverage factor.

Loss Mathematics: Profit and Loss Calculation Formula

There is a simple formula to understand the potential outcome of leveraged trading:

Result = (initial margin) × (percentage change in price) × (leverage)

Let’s consider a specific example. A trader deposits $100 as initial margin, borrows $400 from the exchange, and opens a position of $500 with 5x leverage. If the asset’s price rises by 10%, the trader earns $50, which is 50% profit on their initial investment. After repaying the loan and fees, they will have more than they initially invested.

But if the price drops by 10%, they will lose the same $50 —half of their initial capital. With a sharper decline, their position will be forcibly closed by the exchange.

What Is Liquidation on an Exchange and Why Does It Happen

Liquidation on online exchanges is a forced closing of a trader’s position by the platform when their collateral no longer covers the required margin maintenance. Simply put, when a trader loses enough money that the exchange considers the risk of losing its funds too high, it automatically sells their assets at market price.

Liquidation occurs both in margin trading and in trading perpetual contracts on crypto platforms. The key point: the percentage price movement at which liquidation occurs can be calculated by the formula:

Liquidation percentage = 100 ÷ leverage

With 5x leverage, the position will be liquidated if the price moves against it by 20% (100 ÷ 5 = 20). With 10x leverage, a decline of just 10% is enough.

Real Example: December 2023

Between December 11 and 12, 2023, Bitcoin’s price experienced a sharp drop of over $3 000. This movement triggered a cascade of liquidations across all major platforms. On that day, positions worth approximately $0.5 billion were forcibly closed. Most affected traders held “long” positions, betting on continued price growth—contrary to the downward movement.

Such events demonstrate how risky high-leverage bets are in volatile market conditions.

Why Beginners Fall Into the Liquidation Trap

Novice traders often underestimate the real risks. They see potential profits from using leverage but do not fully realize how quickly their position can be closed if the price moves unfavorably. Additionally, if a trader holds the same asset as collateral (as was possible on some platforms), a price drop hits both the value of their collateral and their position simultaneously, doubling the impact.

Because of the high risk for retail investors, some regulators in various countries have restricted or banned crypto exchanges from offering margin products to private individuals.

How to Protect Yourself: Stop-Loss and Position Management

The most effective tool to prevent liquidation is a pre-set stop-loss order. It works as follows: the trader sets a price at which their position will be automatically sold. Stop-loss parameters include:

• Trigger price: the level at which the order activates
• Execution price: the price at which the asset will be sold
• Volume: how much of the position to sell

If the market price reaches the set level, the order is executed automatically. To increase the likelihood of execution, traders can set the sale price below the trigger price.

Practical Risk Management Scenarios

Scenario 1: High leverage, small position

Suppose a trader has $5 000 in their account. They put up only $100 as initial margin, use 10x leverage, and create a position of $1 000. They set a stop-loss 2.5% below the entry price. The maximum loss will be $25, which is just 0.5% of the total deposit. Without a stop-loss, the position would be liquidated if the price drops by 10%.

Scenario 2: Moderate leverage, large position

The same trader deposits $2 500, uses 3x leverage, and opens a position of $7 500. With a stop-loss 2.5% below entry, the loss is $187.5, or 3.75% of the deposit. Although the leverage is lower, the larger position size results in higher absolute losses.

Conclusion: Planning Is Critical

Both scenarios show that risk depends not only on leverage size but also on the position size relative to the entire account. Professional risk management requires pre-defining:

• How much of your capital you are willing to lose
• Which leverage suits your strategy and experience
• At what level to set stop-loss for each trade

Liquidations on exchanges do not happen randomly—they are the result of poor planning or ignoring the dangers. Understanding these mechanisms helps preserve capital and trade more consciously.