What is Crypto Liquidation and How To Avoid It?

What is Crypto Liquidation and How To Avoid It?

July 18, 2022

Reading Time: 4 minutes

Every crypto investor is concerned about making gains on their investment and avoiding loss of capital. Regardless of where an investor is investing, the main aim is to minimize loss. Therefore, if you invest in cryptocurrency, you must understand what liquidation means. In a volatile crypto space, the liquidation of assets has become a pitfall for users. More so, with the rise of derivatives and crypto futures which give crypto users more leverage to trade digital assets, there is a rise in the liquidation of funds. This is because as futures and derivatives offer leverage for higher profits, they equally enable higher risk margins.

Therefore, this article will explain what liquidation in cryptocurrency means and the best ways you can prevent your funds from getting liquidated.

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What is Crypto Liquidation?

You might know that liquidation traditionally means the conversion of an asset into cash. It could be the conversion of digital assets into cash or the conversion of physical assets such as houses, diamonds, or real estate into cash. So, that is simply converting anything which has monetary value into any money (cash). But in the crypto space, liquidation has a different meaning.

Unlike converting physical assets into cash, crypto liquidation means something else, almost opposite to its traditional meaning. Liquidation in cryptocurrency is an involuntary and automatic action. Liquidation in crypto simply means the closing out of a trade when such trade has gotten to a negative balance beyond the maintenance margin, which leads to liquidation. This means that in a case when the losses on a trade enter negative and surpass the maintenance margin of such trade, leading to the liquidation of all funds in that trade and the closing out of the trader’s position.

Here, the equity of the trade instantly becomes negative. And although liquidation can occur slowly or quickly, depending on the leverage of the trade, huge volatile price swings can cause quick liquidation of funds in crypto funds. So, liquidation wipes off the initial investment of traders on a particular trade. This wipe-out can slowly occur when there is little leverage on the trade and quickly when the trade has high leverage margins.

As a crypto trader, it is important to be careful of high leverage trades; they can easily liquidate your trades. An ideal situation for liquidation is when a crypto trader can no longer meet the required margins for a certain leveraged position in a trade. Then, the exchange is forced to liquidate the funds in that trade. Imagine holding a 20x leveraged position on ETH/USDT with $100 as your account balance. If the price of ETH was to drop lower by 5%, your account would be liquidated as you would be unable to fulfil the margin requirements to maintain such trade. Therefore, you must understand the risks of leveraging before you use them.

How to Avoid Crypto Liquidation

Now that you understand what it means to get liquidated in cryptocurrency. Let us discuss some ways to ensure that you do not lose your funds by getting wiped out of the market.

  • Plan with Stop Loss Orders

You must enter the crypto market with a plan. Do not follow crowd sentiment without having a plan for each trade you open. Thus, to avoid getting liquidated in the market, ensure that you open stop-loss orders. A stop loss is simply an automated action where you set a price at which the trade should close if the market goes against your strategy. Most crypto exchanges offer traders the option to include stop loss in their trade, which is one of the best ways to avoid liquidating assets. It helps to minimize traders’ losses in the face of an opposite market move.

  • Consider Lower Leverage

As previously mentioned, liquidation is very dependent on leverage. So, while higher leverage provides a higher margin for profit, it also offers higher risk such that a little change in price direction can cause significant loss.

So, to avoid trade liquidation, you should consider using lower leverage, as this is safer.

  • Margin Ratio

Another way you can avoid liquidation in crypto is to monitor margin ratios. When margin ratios reach 100%, the trade is liquidated. You can monitor the margin ratio to ensure it doesn’t hit 100% before closing the trade, or you can add more margin to keep the trade alive and prevent it from liquidating.

Conclusion

In summary, liquidation in crypto is one you want to avoid and protect yourself against. The best way to do that is to combine all three strategies above. Creating a stop loss based on the leverage used is advisable (that is, using a leverage calculator), while margin ratio monitoring can save you from regret and liquidation.

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Marvy
Marvy
29 days ago

Quite explanatory and clear.
Can you do an article on short squeeze?

Thanks.

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