How a Liquidation Order Is Executed: Liquidation Price vs. Bankruptcy Price
Main Takeaways
Liquidation occurs when the margin balance falls below the maintenance margin. The liquidation price is the point at which a trader’s position starts entering liquidation.
The bankruptcy price is the point at which a trader’s losses equal the collateral value deposited or the initial margin.
In a liquidation order, the liquidation price corresponds to the stop price, while the bankruptcy price is the limit price at which the order will be executed.
Traders often face liquidation in cryptocurrency futures. Beginners unfamiliar with cryptocurrency derivatives may find the execution of liquidation for their open positions confusing.
On Binance Futures, a liquidation order is executed by taking into consideration the liquidation price and the bankruptcy price. These are the two important price points traders need to be aware of when trading perpetual contracts. This article looks at the roles of the liquidation and bankruptcy prices in the execution of a liquidation order.
The Basics of Liquidation
Liquidation occurs when the margin balance falls below the maintenance margin. Margin balance is the sum of a wallet balance and unrealized PnL, while maintenance margin is the minimum amount of margin traders must maintain in order to keep their futures position open.
On Binance Futures, liquidation occurs at Mark Price, which is the estimated true value of a contract. The Mark price considers an asset's fair value to prevent unnecessary liquidations during a volatile market. On the other hand, Last Price refers to the latest traded price of a futures contract on Binance.
Liquidation Price vs. Bankruptcy Price
Liquidation price is the price at which a position will start going into liquidation. There are several factors that can influence this threshold, including the leverage used, the maintenance margin rate, the cryptocurrency’s current price, and the trader’s remaining account balance.
Bankruptcy price is the price at which a trader’s losses become equivalent to the collateral value deposited or the initial margin. It’s the point at which the margin balance of the liquidated user will be equal to zero.
How is a liquidation order executed?
We’ll now explain how a liquidation order is executed in the context of these two prices. In practice, a liquidation order behaves similarly to a limit order placed at the bankruptcy price. But for a better illustration, let's look at the execution of liquidation orders as a two-step stop-limit order.
In a stop-limit order, you choose a stop price (either the Last price or Mark price) and a limit price at which your order will be executed. When your position reaches the stop price, the limit order will be triggered and executed at the limit price.
Let's consider a liquidation order to be a stop-limit order with the trigger type price as the Mark price. A stop-limit order is triggered when your position reaches the Mark price. In a liquidation order, the liquidation price is the stop price, and the bankruptcy price is the limit price at which the order will be executed.
So when the contract's price surpasses the liquidation price, the liquidation process starts. The bankruptcy price is the limit price at which a user's margin balance will be liquidated.
Insurance funds
Binance Futures uses Insurance Funds to protect bankrupt traders from losses and guarantee that the profits of successful traders are fully paid out.
As we’ve seen, traders are subject to liquidation when their collateral is less than their maintenance margin. When these traders are unable to sell their positions or have a negative account balance after all positions are liquidated, they are declared bankrupt. In this situation, Binance takes control of their remaining positions.
Suppose a trader's position is liquidated at a higher price than the bankruptcy price (meaning their losses do not surpass their initial margin). In that case, any remaining funds earned will go to the insurance fund.
However, if the liquidation price is lower than the bankruptcy price, the trader's losses would have exceeded their initial margin. In this event, the Insurance Funds will cover the deficit.
Conclusion
It’s vital to familiarize yourself with the concept of liquidation and how to prevent it before engaging in cryptocurrency derivatives trading. Liquidation occurs when an individual is unable to meet the required margin for their leveraged position on the market.
To avoid liquidation, it’s advisable to closely watch your margin ratio, use leverage responsibly, avoid accumulating more contracts in a losing position, and utilize trading tools such as stop-loss orders.
Read the following articles to learn more about liquidation in crypto trading and how to avoid it:
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