The crypto industry, despite all the market swings, continues to grow and attract new investors from all over the globe. These people go for different trading strategies depending on their goals, experience, funds available, etc. Leverage trading is one of the strategies that allow borrowing the necessary money to create positions. However, along with great opportunities, it also poses great risks of losing everything.
In this article, we are shedding light on cryptocurrency liquidation – the process closely connected with leverage trading. We will discuss what is liquidation, what it means for traders, and how to avoid it.
Before we actually dive into the crypto liquation, we first need to explain what margin and leverage trading are.
Margin trading is about borrowing money from the exchange to increase your position’s price. This approach is useful for investors who don’t own large amounts but want to participate in big trades. On the one hand, margin trading helps to multiply the invested funds if the trade ends up being beneficial. On the other hand, if the trade is unsuccessful, one will probably lose all the investments.
Let’s have a look at the following example: you can only invest $100. Let’s say you borrow an additional $900 from a crypto exchange. Now, you can start a trade with a total of $1,000, and the leverage would be x 10. The degree of leverage is the correlation between the initial margin (the sum one actually owns) and the borrowed amount.
So what all this has to do with liquidation? We will now go back to the definition of what is liquidation.
To liquidate means to exchange assets into cash. This can happen for different reasons, but usually, the main cause for liquidation is saving your investments in case of unsuccessful trading (when the market goes down). Then such an exchange of assets into cash would be called voluntary liquidation.
The second type of liquidation is called forced – when an exchange has to liquidate assets and close the position to save the funds they’ve borrowed to investors. What’s more, a borrower also needs to pay a liquidation fee. And below we will talk in detail about voluntary liquidation.
In margin trading, an exchange will need a required deposit amount so that you can borrow money from them. In other words, you need to make collateral – an initial margin. Further on, you leverage this sum and start trading. In case market conditions get difficult, the exchange will do a forced liquidation. In such a way, a company is attempting to save the funds they’ve borrowed.
Margin is an agreed trade percentage that should be deposited in fiat currencies before an investor can open a position using funds from the exchange. If a margin goes lower than this amount, an exchange will automatically close a position. Sometimes, one might receive a margin call – a request to deposit more money to meet the liquidation threshold.
With the above example, if the asset’s price slurping, the initial margin will take the first hit. If the negative trend continues, it means that the borrowed capital should be affected next. Consequently, the exchange wants to liquidate the position to protect itself from losses. Therefore, in the crypto market, liquidation does not bring many advantages for traders. Even the most popular coins Bitcoin and Ethereum are highly volatile and unpredictable. That is, even if in the future your position’s price could recover, an exchange will start liquidation as soon as the loss equals the initial margin.
We’ve prepared a few tips on how one can bypass crypto liquidation or, at least, minimize risks.
Monitoring this indicator will help to determine when your position will be liquidated. If you want to avoid liquation, you can deposit more money to cover the initial margin.
If you’re borrowing money anyways, a bigger amount can be a huge temptation. However, remember that lose and win chances are the same in margin trading. That is why if you don’t want your assets to be liquidated, it’ll be a wise decision to stick to the smaller leverage rates.
This is a safe and secure way to prevent your positions from liquidation and avoid losing investments. With a stop-loss order, you’re safely exiting a trade when the asset’s price reaches or falls to a pre-set level. Compared to leveraging, you don’t need to pay a liquidation fee if you’re making stop-loss orders.
To sum up, margin trading and leveraging undoubtedly have their benefits, especially for those traders who don’t have enough money for investors. Still, cryptocurrencies are notoriously famous for their volatility, which makes leveraging a tricky game. The major drawback of forced crypto liquidation is that you will need to pay a liquidation fee. Monitoring the margin ratio, reducing the leverage rate, and using stop-loss orders are just a few ways how traders can prevent liquidation.
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