LIQUIDATION: what is it and how to avoid getting put back on the main crypto exchanges
Over the past few weeks, two major crypto exchanges, Binance and FTX, have had to reduce the leverage that traders can use. This follows pressure from authorities, claiming that high leverage on derivatives such as futures and options causes many traders to lose their funds.
In crypto futures trading, losing positions are forced out to prevent traders from falling into negative equity.
SEE ALSO: Why major exchanges reduce leverage to just 20 times
Leveraged positions are subject to volatile price movements which can send a trader’s investment into negative balance almost instantly.
In such situations, losses may be greater than the maintenance margin. As a result, the losers are liquidated. This process is involuntary and automatic if a transaction meets specific price criteria.
Let’s say you had to open a trade with $ 100 and with a leveraged position while waiting for the price of BTC to rise (long). The leverage you used is 20x so your position is worth $ 2,000.
If the price of BTC only fell 5%, you would wipe out the initial $ 100 margin completely. If you cannot meet margin call requests to keep the trade afloat, your position is now at risk of being liquidated.
Tips to avoid liquidation
There are basically 2 ways to avoid being liquidated:
- Add funds to increase your margins
- Use leverage more responsibly
Traders can apply more margin as the position gets closer to 100%.
This involves monitoring their initial deposit (margin) and comparing it with the price movement, and adding funds to increase the margin so that the position does not hit the liquidation point.
Doing this effectively reduces the leverage taken.
With liquidation expected to occur at 100% of a trader’s initial deposit, traders rely on specific margin ratios based on the margin they take. From the example transaction, taking a leverage of 20x, the margin ratio goes from 100% in the initial deposit to 5%.
Traders can also apply stop loss orders that allow them to automatically set a sell price if the price of an asset drops or exceeds that predetermined price. This feature is available on all futures trading platforms.
While you can still lose funds, the stop loss tool will protect you from losing everything on a trade and having to pay liquidation fees.
The most effective way to prevent liquidation is to leverage responsibly. Leverage has a significant impact on the longevity of a trade. While it may be tempting to use large amounts of leverage, lower levels of leverage will always be a safer route.
A high use of leverage can indeed lead to large gains. However, it could also magnify your losses.
RECOMMENDED READING: How to invest in Bitcoin futures trading
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