As someone who lost huge funds on Bitcoin due to forced liquidation, I have decided to write an expert guide shielding my mutuals from falling into a similar quagmire.

Overview:

What is liquidation?
Liquidation in action: A real-life scenario
Types of liquidation
“Surge liquidation”
How to avoid liquidation
Total liquidation attributed to Bitcoin spot ETFs

What is liquidation?

In general financial terms, liquidation simply means selling assets for cash. When you’re liquid, in commonplace terminology, you have accessible and moveable cash. On the contrary, liquidation in the cryptocurrency landscape means more of a nightmare. It refers to a situation where a trading position closes because the trader has insufficient funds to keep their leverage active. I’ll explain.

To begin, we need to briefly touch on derivatives. These are contracts that allow traders to bet on an asset’s future price in a bid to increase their earning potential. Margin trading, futures trading, and perpetual swaps are examples of derivatives products. With margin trading, for instance, traders borrow funds from crypto exchanges (like Binance and BitMex) and the borrowed funds are added to the trader’s initial margin to open a trading position. This initial margin acts like an insurance fund for the crypto exchange in case the trade goes against the trader. If the trading goes by the trader’s initial bet, the trader makes money. If it goes against the trader’s bet, the crypto exchange takes the initial margin the trader staked partially or totally. This act of losing the previously staked initial margin is known as liquidation.

Liquidation in action: A real-life scenario

Now let’s be more practical. Suppose I plan to do a 5x leverage on a digital asset with an initial margin of $100. This means I will borrow $400 from Binance so that I can have a trading position between $100 and $500. Let’s imagine that the price of the asset increases by 10% during my leveraging period, meaning I’ve made a profit of $50 from a $500 leverage position (meaning I’ve made a 50% profit on my initial margin). I will repay Binance its $400, and I keep $150 to myself.

Cool huh? But this positive consequence doesn’t always happen in real life. The price of the asset could have also dropped by 10% during my leverage and I would have lost $50. Binance will still take its $400 from me but this time I’ll be left with $50.

This is a $50 liquidation and it is partial. There are situations when the asset’s value may drop by more than 10% and the trader loses all his stake and is left with nothing. In this situation, the trader experienced a total liquidation.

There’s a formula you can use to calculate your leverage, though:

Profit or Loss = (Initial Margin) x (% price movement) x (leverage)

“leverage” is how much your initial margin can gain or lose, and it’s a rule of thumb to always keep your losses at manageable and affordable levels.

Liquidation % = 100 / leverage

If you use a 10x leverage, you can use this formula to determine the point at which your position will be totally liquidated, which in this case is when the asset moves against your position by 10%.

Types of liquidation

As initially presented, partial liquidation involves the trader cashing out of his stake to prevent further loss of the entire initial margin while total liquidation involves total loss of the initial margin because their asset has unbearably moved against the leveraging position. Total liquidation is usually forced.

Voluntary liquidation happens when the trader decides to cash out from a losing trade or for other reasons best known to them, while forced liquidation occurs when the crypto exchange (that borrowed the trader part of the leveraging fund) closes the trader’s position to prevent further losses. Interestingly, liquidation can happen without derivatives leveraging.

“Surge liquidation”

Without futures trading, you can simply hold a digital asset and still get liquidated, an instance I termed “surge liquidation”. It happens when someone holds a digital asset which later crashes significantly, rendering the holder’s asset valueless.

This happened with LUNA in 2022. As of April 6 of that year, LUNA hit an all-time high of $116 causing several people to buy and hold the prospective magic coin. By June 6, the value dropped to $0.00008, leaving holders with worthless stacks of LUNA coins. They got liquidated.

How to avoid being liquidated

Well, in leveraging, the most important lesson anyone can learn is not to be too greedy and to “follow who know road”. There is no globally accepted standard to trading but your primary goal should be to keep your losses at minimal levels even before considering profits. This is because when you don’t have the funds to leverage with, you can’t trade at all. Also, be conversant with information about your leveraged assets to anticipate any potential volatility. Get a mentor with a verifiable track record who can guide you through your trading journey.

You need to utilize the “stop loss” feature on your crypto exchange too. There is no golden rule on setting stop losses but it’s always helpful to target 2-5% of your trade size. Additionally, never overleverage. To mention again, greedy traders are always the quickest to exit the business. Effectively manage your trading size and the associated risk. Note that the higher you leverage, the more likely your chance to get liquidated. Then, to prevent surge liquidations, you have to go for an asset with good market value and consider diversifying your portfolio. Various articles on NODO already demystified everything you need to know about choosing the right crypto assets.

Total liquidation attributed to Bitcoin spot ETFs

Although everyone is clamouring about the positive impact spot ETFs would potentially bring, its pre-approval period caused huge losses in the crypto industry. From the fake Bitcoin ETF approval tweet by the US SEC to the various news shocks, the market lost over $220 million to liquidations.

Closing thoughts

Crypto liquidation is a nightmare to traders and holders but that doesn’t mean there is no prosperity in the crypto industry. The solution to survival in the crypto space is the access to the right information and this guide aims to bring that to your fingertips. As you’ve already learnt a lot about crypto liquidations, the types, how to calculate them, and the practical examples, I trust that everyone is well-equipped to safely interact with digital assets going forward.