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November 28, 2023

Universe: What Does Liquidation Mean in Crypto Futures & Perps Trading?

The Nature of Cryptocurrency Trading

Given the insane volatility in the crypto markets, with large price swings tied in with a lack of regulation, cryptocurrency trading can be very profitable or can incur huge losses for the trader. Understanding how one gets liquidated or comprehending how one can avoid liquidation can accrue huge benefits for the trader, especially when it comes to margin preservation and planning your trades.

Today we are going to look at how liquidation levels are a key issue in being a better cryptocurrency trader.

Given the innate nature of the crypto markets, liquidation risks is an inherent “knock-on” effect because of large price swings in a short period of time. One can see examples of this in previous debacles like the FTX token, LUNA/TERRA episode, and even DOGE, depending on the direction of the token or coin.

In general, liquidation in its essence, means how one can turn an asset into cash, in a given amount of time. In crypto trading, this term is slightly different and goes hand in hand with the amount of leverage one uses.

During a drop in the price of a crypto asset, some exchanges will sometimes close a trader’s leveraged position forcibly. This also depends on the trader’s margin levels and whether he or she has sufficient funds to keep a leveraged trade open. 

Whether a trader is able to meet the margin call of the trade in relation to the exchange’s requirements in terms of sufficient liquidity in funds his account - This is known as margin trading and goes hand in hand with liquidation risks.

Should the market move against your leveraged position to a large degree, the trader may lose his entire margin and his open trade position could be liquidated- all the more expounded by the amount of leverage he uses.

The higher the leverage, the higher the liquidation risks proportionate a given amount of funds in his margin trading account.

When this large unfavorable movement happens, the trader’s entire initial capital input can be “lost” to the exchange. This is also one of the reasons, an exchange will “warn” the trader that his position is approaching risky “margin levels” or dangerous liquidation levels.

Should this happen, the exchange will profit from the trader’s loss and until the trader deposits more funds into his account, he would unlikely be able to take another trade.

This highly applies to crypto derivatives where the risks are higher, namely, - perpetual swaps and futures. 

The reason why the exchange has to liquidate in these instances is so that the trader does not lose any more money, otherwise the exchange will have to bear the further loss, past the initial margin posted by the trader. Hence, from the position of the exchange, it is not necessarily a bad thing.

Different Types of Crypto Liquidations

Two main types of liquidation are present here.

Partial Liquidation. 

This occurs at an early stage before all of the initial margin is “lost”. The objective is to prevent a huge loss for the trader and its terms are dependent on the preset contract between a trader and his exchange. Hence, it pays to understand the terms and conditions of the exchange before trading.

Total Liquidation.

Same thing happens in this instance whereby all of the initial margin is “lost” and the trader loses all of his invested capital in his margin account, and in some cases, might have to pay off a negative balance. This highlights the importance of the early warning signals of a partial liquidation.

Essentially, liquidations are part and parcel of derivatives trading especially in cryptocurrency margin trading whereby traders are essentially “borrowing money” to increase their trading volume via leverage.

They are somewhat a necessary evil or a valid good depending on how one is consistent or profitable in their trading journey, and whether their directional bets are in tune with the asset at that point in time.