Aside from the decentralized nature of cryptocurrency, high volatility, which causes fluctuation and instability in the asset's price, is another common feature that can be a major turn-off for investors and traders. However, traders tend to make their fortune from the price difference of an asset over a given period.
Trading crypto assets on the spot market gives quick gains in the market. However, to increase the chances of making more profits from trades, traders explored cryptocurrency derivative trading, such as margin trading, futures, and perpetual swaps. Derivatives trading allows traders to leverage assets borrowed from crypto exchanges to increase their chances of potential earnings from trades.
For example, in margin trading, a trader can open a position for trade by leveraging on borrowed assets from an exchange. This entails borrowing funds from the exchange and adding them to the initial amount available to trade to increase its potential profit. So, if a trader starts with $1,000 and uses 4x leverage, the total trading amount will be $5,000, putting the trader in a better position to profit.
However, the constant fluctuation in cryptocurrency prices and a decline in asset value could lead to a forceful trade closing, referred to as Liquidation.
What is Liquidation?
In traditional finance, Liquidation refers to shutting down a business and handing over the assets to a claimant to settle a debt or end an insolvent company crisis. Similarly, in cryptocurrency, liquidation refers to the selling of crypto assets for cash to minimize losses in the event of a market crash. However, liquidation is mainly attributed to traders who leverage funds from an exchange to trade high volumes of assets in cryptocurrency derivative trading. Hence, it is the forced closing of a trader's trading position due to partial or complete loss of the initial trading capital.
A partial liquidation occurs early in the trade and closes the trade position partially to reduce the position and the leverage used by the trade. Complete Liquidation happens when all of the leverage in trade has been used, and the initial margin has been exhausted in a trade.
What Causes a Crypto Liquidation?
Crypto liquidation occurs when a trader cannot meet the exchange's requirements and is thus forced to exit the trade position. As a result, the exchange allows the trader to increase the size of their trading position, which is leverage. As a result, an initial fund representing the portion of the trade's value that will be used as a margin must be deposited with the exchange to open and maintain a trade position.
Consequently, the position automatically starts liquidating when a trader's margin falls below the agreed point with the exchange. If the trader does not put up more margin and the leveraged position reaches its threshold, the trader gets a margin call when the free margin falls below zero. As a result, the trader is forced to choose between automatically liquidating the trade position or adding more money to the margin account to bring the leverage back up to the exchange requirements.
How to avoid Liquidation?
Trading in cryptocurrencies involves taking losses, but Liquidation is not always necessary. There are a few ways to reduce the likelihood of being liquidated when using leverage.
Use Stop Loss
A stop loss is an advance trading order that a trader activates on a cryptocurrency exchange and instructs the exchange to sell an asset when its price reaches a specific level. Understanding how much a trader is willing to lose is the first step in risk management for cryptocurrency trading. When a trade reaches a specific price point, most trading platforms allow the stop loss to activate automatically. When setting up a stop loss on a trade, you must specify the price at which you want the order to execute, the rate at which you want to sell, and the quantity of the asset you're trading. Although you might still lose your asset, you will not go beyond a certain point, so you will not risk Liquidation. Hence, a stop loss is primarily used to limit potential losses.
Lower Your Leverage
When trading with leverage, you must keep an eye on the liquidation price. Although, by using more leverage, you increase your chances of making profits. It is, however, detrimental in the event of a loss because the higher the leverage, the closer the liquidation price is to your entry. As a result, keep yourself safe by using less leverage.
Monitor the Margin Ratio
Monitoring the margin ratio is one of the crucial ways of avoiding Liquidation. This involves making sure the margin doesn't fall below the exchange requirement. Hence, a trader can maintain the position by adding more whenever the margin exceeds the agreed point. By doing this, a trader can trade for a long time in this way without worrying about Liquidation.
The Takeaway
A trader is liquidated if they don't follow the rules for trading on the exchange. As a result, it is crucial to comprehend Liquidation and how to avoid it before engaging in cryptocurrency trading, whether through margin trading, futures trading, or perpetual swaps.
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