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Crypto Futures Basics: What is Liquidation and How to Avoid it?

2021-08-02

TL, DR:

  • Leveraged positions are prone to volatile price swings, which may cause a trader’s equity to plunge into negative balance instantaneously. In these situations, losses can be larger than the maintenance margin.

  • Liquidation mechanisms help prevent traders’ account from falling into negative equity.

  • There are available tools to prevent liquidation from happening, such as monitoring margin, using stop-losses or using lower leverage.

Getting started with trading can be quite daunting. There are many rules and possibilities that should be considered before entering into the world of futures trading. One of the keys to success with trading is strategizing each trade carefully and understanding how much capital is at risk. 

Especially in futures trading, where leverage is easily accessible, knowing how much capital and leverage is vested into a trade will help you understand your total risk exposure, because in some cases, losing trades may end up being liquidated.

What is liquidation in crypto futures trades?

Traditionally, liquidation is a term that simply means converting assets into cash. In futures trading, liquidation is something to avoid as much as possible. With crypto futures trades, losing positions are forced-exited to prevent traders from falling into negative equity. Leveraged positions are prone to volatile price swings, which may cause a trader’s equity to plunge into negative balance instantaneously. In these situations, losses can be larger than the maintenance margin. As a result, the losers are liquidated. This process is involuntary and automatic if a trade has come to meet specific price criteria. 

Liquidation can happen either slowly or quickly, depending on the amount of leverage used in a trade. For example, with lower amounts of leverage, liquidation won’t happen as soon as a minor correction occurs in the market. In contrast, higher amounts of leverage can deplete traders’ initial investment with little to no effort. 

When would liquidation occur?

A forced liquidation process happens when an investor or trader can no longer meet the margin requirements of their leveraged position.

Take a simplified example. Let’s say you were to open a trade with $100 and with a leveraged long position in the BTC/BUSD. The leverage you took up is 20x, making your position worth $2000. If BTC’s price were to drop only 5%, you would completely wipe out the initial margin of $100. If you cannot fulfill the margin call demands to keep the trade afloat, your position is now at risk of liquidation.

Although this is a basic example, it is crucial to know your limits, how much you’re willing to lose on a trade and be strategic with leverage. This is especially true with the volatility of cryptocurrencies. This is why we have introduced the leverage limits for new accounts to protect our new users from the dangers and unintended consequences of using high leverage.

At Binance, we believe that all our clients should fully understand the impact of leverage and the circumstances under which it can significantly damage the probability of a profitable trade. We also believe that allowing excessive leverage is not in the interests of our clients, our firm, or our industry. Read more about how to reduce your chances of liquidation in our support pages.

3 Tips to Prevent Liquidation

There are ways to avoid liquidation in a less general sense. Traders should remember that losing out on trades is always possible, but liquidation does not always have to occur. There are available tools to prevent this from happening and smarter trading strategies to consider, such as monitoring margin or using lower leverage.

1. Use a Stop Loss 

Firstly, the most obvious answer in avoiding liquidation is simply using a stop loss above the liquidation price. A stop loss is a trading tool most exchanges offer, which allows traders to set a price to sell at automatically, should the price of an asset fall to or beyond this predetermined price. Using a stop loss in conjunction with a liquidation calculator, traders can protect their funds from being lost as a whole, and especially from liquidation.

Although you may still lose some funds, the stop loss tool will protect you from losing everything on a trade and from having to pay a liquidation fee. Besides, who wants to lose and get penalized for it? By using a stop-loss, you can prevent this from happening. 

2. Use Lower Leverage

Leverage has a significant impact on the longevity of a trade. While it may be enticing to use large amounts of leverage, lower amounts of leverage will always be a safer route. High use of leverage can indeed lead to major wins. However, it could also magnify your losses.

As demonstrated above, the high amount of leverage can hurt a trader even when a small price change occurs. Using lower leverage will help you navigate a volatile crypto market smoothly and safely. 

3. Monitor the Margin Ratio

Another option that traders can implement is monitoring the margin ratio. When the margin ratio hits 100%, the position will be liquidated. To avoid this outcome, traders can add more margin to their trade and reduce their position (returning leverage). This method is akin to keeping a position alive when the ratio is nearing 100% (when the trade is heading further in the wrong direction). 

Adding more margin or reducing leverage is similar to starting with less leverage in the first place. The difference is that maintaining a specific margin ratio can be done over longer periods and is a dynamic solution.

In Summary

Liquidation is a scary word that traders would much prefer to avoid if possible. The good news is that traders have several tools and trading strategies that they can implement to avoid ever being liquidated. From stop losses to liquidation calculators, appropriate usage of leverage, and monitoring margin ratios, traders have multiple resources to avoid liquidation. 

Liquidation is only one of the things traders need to be aware of when learning how to trade. If you think you might want to learn more about trading, Binance offers everything a trader may need to get trading responsibly. In addition to this article, Binance Academy is always available as a source for best trading practices, trading terminology, and trading tools. Discover Academy’s Ultimate Guide to Trading on Binance Futures

Beyond this, Binance offers incredibly competitive rates, fees, and options for traders. More info on margin and futures trading can always be found on Binance Academy, and getting started on Binance is very straightforward.

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