Liquidation In Cryptocurrency (2024)

During the past week, a crypto trader purportedly suffered a $1 million loss in USDT overnight while engaging in margin trading of the meme coin PEPE on Binance.

Identified under the pseudonym Crypto Nerd on X (formerly Twitter), the trader disclosed the losses on April 13. Crypto Nerd elaborated that they had initiated a 3x-leverage long position on PEPE, utilizing $1 million worth of Tether's stablecoin USDT.

The situation took a distressing turn considering the trader's financial circ*mstances; reportedly, he possess less than $1,000 in his bank account.

What is Liquidation?

In the cryptocurrency market context, liquidation occurs when an exchange forcibly closes a trader's leveraged position due to either partial or total loss of the trader's initial margin. This happens when the trader fails to meet the margin requirements for a leveraged position, lacking sufficient funds to sustain the trade.

Both margin and futures trading can experience liquidation events. Leveraged trading is inherently high-risk, with the potential for a complete loss of collateral (initial margin) if the market moves significantly against the leveraged position. Recognizing the risks involved, some jurisdictions like the United Kingdom have banned crypto exchanges from offering leveraged trading products to retail investors, aiming to safeguard novice traders from liquidation and the subsequent loss of their invested capital.

To gauge the vulnerability of a leveraged position to liquidation, traders can utilize a simple formula:

Liquidation % = 100 / Leverage

For example, employing 5x leverage means the position will be liquidated if the asset's price moves 20% against the trader's position (100/5 = 20). This calculation provides traders with insights into the level of market movement required to trigger liquidation, assisting in risk management strategies.

What are Types of Liquidation?

Crypto liquidation encompasses two primary types: partial liquidation and total liquidation. These variations primarily differ in the degree to which a trading position is closed.

1. Partial Liquidation: In partial liquidation, only a portion of the trading position is closed. This could involve selling a portion of the cryptocurrency asset to mitigate losses or reduce exposure to market risks while keeping some of the position open.
2. Total Liquidation: Contrastingly, total liquidation involves closing the entire trading position. In this scenario, all holdings of the cryptocurrency asset are converted into fiat currency or stablecoins, effectively exiting the market entirely.

Both types of liquidation serve distinct purposes and are implemented based on the trader's strategy, risk tolerance, and market conditions.

How to avoid liquidation

When employing leverage in trading, employing risk mitigation strategies is crucial, and one such strategy is the implementation of a "stop loss."

A stop loss, also referred to as a "stop order" or "stop-market order," is an advanced instruction that an investor issues to a crypto exchange, directing the exchange to sell an asset once it reaches a specified price level.

Setting up a stop loss involves inputting several parameters:

• Stop Price: The price at which the stop loss order will trigger.
• Sell Price: The price at which you intend to sell the cryptocurrency asset.
• Size: The quantity of the cryptocurrency asset you plan to sell.

When the market price reaches the stop price, the stop order is automatically executed, and the asset is sold at the specified price and quantity. To enhance the likelihood of the order being filled swiftly, traders may set the sell price slightly lower than the stop price, increasing the probability of the order being matched by another trader. This precaution is particularly useful when traders anticipate rapid adverse market movements.

Look at the two scenarios below:

Scenario 1:

• Trader's account: $10,000
• Initial margin: $200
• Leverage: 5x
• Position size: $1,000
• Stop loss distance: 3%

Potential loss with a stop loss: Potential loss = Position size Stop loss distance = $1,000 3% = $30

This represents 0.3% of the trader's entire account size ($30 / $10,000).

Without a stop loss, the position would be liquidated if there's a 15% drop in the asset's price, risking the entire initial margin of $200.

Scenario 2:

• Trader's account: $15,000
• Initial margin: $3,000
• Leverage: 5x
• Position size: $15,000
• Stop loss distance: 2%

Potential loss with a stop loss: Potential loss = Position size Stop loss distance = $15,000 2% = $300

This represents a 2% loss from the trader's entire account ($300 / $15,000).

The lesson remains the same: while higher leverage can amplify gains, it also increases potential losses, especially with larger position sizes. Managing risk effectively is paramount, with a suggested guideline of keeping losses per trade below 1.5% of the entire account size.

Setting A Stop Loss

Determining where to set a stop loss is a critical decision that depends on various factors, including your risk tolerance, trading strategy, market volatility, and the specific characteristics of the asset being traded. Here are some considerations to help you decide where to set your stop loss:

1. Support and Resistance Levels: Identify key support and resistance levels on the price chart. Setting your stop loss just below a support level or above a resistance level can help protect your position from significant price movements against your trade.
2. Volatility: Consider the historical volatility of the asset. If the asset tends to experience large price swings, you may need to set a wider stop loss to allow for fluctuations while still protecting your position.
3. Risk-Reward Ratio: Determine your risk-reward ratio for the trade. Ideally, your potential reward should outweigh your potential risk. Set your stop loss at a level that aligns with your desired risk-reward ratio.
4. Technical Indicators: Use technical indicators such as moving averages, Bollinger Bands, or trendlines to identify potential entry and exit points. These indicators can help you identify areas where price movements are likely to reverse or continue.
5. Market Conditions: Consider the current market conditions, including news events, economic data releases, and overall market sentiment. Set your stop loss accordingly to account for increased volatility or unexpected price movements.
6. Timeframe: Determine your trading timeframe and adjust your stop loss accordingly. Short-term traders may set tighter stop losses, while long-term investors may set wider stop losses to allow for more significant price fluctuations.
7. Trailing Stop Loss: Consider using a trailing stop loss, which automatically adjusts your stop loss level as the price moves in your favor. This allows you to lock in profits while still protecting against potential losses.