What is liquidation on exchanges. How people lose millions on bitcoin hikes
Bitcoin surges in December led to liquidations of traders' positions for $0.5 billion
When cryptocurrency rates spike, analytical services record liquidations of traders' positions worth hundreds of millions of dollars. We tell you how it works and how to minimize the risks of leveraged trading
Cryptocurrency exchanges give traders the opportunity to increase the size of trading positions through the use of derivative products such as margin trading, open-ended swaps or futures. The first cryptocurrency derivatives appeared back in 2011 and have gained popularity over time, especially among retail traders looking to maximize their returns on exchanges.
Binance, Bybit or OKX are examples of cryptocurrency exchanges that allow customers to trade cryptocurrencies and cryptocurrency derivatives with leverage. In so-called margin trading, borrowing funds from an exchange to build up trading positions can increase a trader's potential profit, but similarly increases their risk of losing their invested capital.
There are analytical tools that can track data on crypto exchanges' wallets and their users' trades, so services such as Coinglass or numerous bots on X or Telegram can monitor real-time data on margin position liquidations on major trading platforms.
According to Coinglass data, on December 11-12, 2023, when the Bitcoin price plummeted by over $3,000, triggering a decline in the prices of other cryptocurrencies, traders' positions were forcibly closed, totaling around $0.5 billion. The majority of liquidated traders held long positions, betting on the continued rise of Bitcoin or other cryptocurrencies.
Margin trading involves increasing the amount allocated for a trade by leveraging external funds from the exchange. This enables investors to enlarge their trading positions through leverage.
To open a margin trading position, the exchange requires a certain amount in cryptocurrency or fiat as collateral, known as the "initial margin." This deposit acts as insurance for the exchange in case the trade goes against the borrower.
The amount that can be borrowed from the exchange in relation to the initial margin is determined by the leverage ratio. For example, with a 5x leverage and an initial margin of $100, a trader borrows $400 from the exchange to increase the trading position from $100 to $500.
Each trade can yield more profit or loss depending on the leverage ratio. A formula to calculate potential profit or loss when using leverage is: Profit or Loss = (Initial Margin) x (Percentage Change in Price) x (Leverage).
In the context of cryptocurrency markets, liquidation occurs when the exchange forcefully closes a trader's leveraged position due to partial or complete loss of their initial margin. This happens when the trader cannot meet the margin requirements for the leveraged position, lacking sufficient funds to sustain the open trade. Liquidation occurs in both margin and futures trading.
Trading with leverage involves a high risk of losing the entire deposit (initial margin) if the market significantly moves against the trader's position. Some exchanges set limits on traders' levels, and regulators in certain countries have prohibited cryptocurrency exchanges from offering leveraged products to retail investors to protect them from liquidations and capital loss.
To determine the percentage change in asset price against the position that would lead to liquidation, you can use the formula: 100 / Leverage Ratio. For example, with a 5x leverage, the position will be liquidated if the asset's price moves against the position by 20% (100/5 = 20).
One way to reduce the likelihood of liquidation when using leverage is through a "stop-loss." This is a pre-order placed by the trader on the exchange, instructing it to sell the asset when it reaches a specific price level.
When setting up a stop-loss, several parameters are defined:
- Stop Price: The price at which the stop-loss order will be executed.
- Sell Price: The price at which the trader plans to sell the specific asset.
- Quantity: The amount of the asset the trader plans to sell.
The primary goal of a stop-loss is to limit potential losses.
The size of leverage, position, and stop-loss should be determined based on the strategy and risks involved. Smaller leverage does not necessarily minimize losses in the case of an incorrect position. Risk management is crucial, so traders should carefully plan for market movements that deviate from expectations.