This article focuses on the process of liquidation in derivatives trading. It explains what triggers a liquidation, the steps involved in the liquidation process, and how traders can manage and mitigate the risks of liquidation.
Definition of liquidation in trading
In finance, liquidation simply refers to the concept of converting assets into cash. Businesses that declare bankruptcy may liquidate (sell) their assets—as small as bonds, or as big as buildings—so they can repay their debts. Similarly, trading platforms liquidate their users’ collateral when the market moves against risky, leveraged trades.
Derivatives are financial tools that offer traders the opportunity to make leveraged trades. In cryptocurrency markets, these most commonly include financial instruments like futures, options, and perpetual swaps. In different ways, these tools allow traders to use a low amount of capital to control funds with higher value. However, because the losses are amplified along with the profits, this presents a greater degree of risk. Therefore, traders must put forth a pre-defined amount of collateral (called initial margin), which represents the funds “at risk” in the trade.
To manage the risk of leveraged trading, platforms offering derivatives trading build in a safety mechanism: liquidation. Through liquidation, a losing trade is automatically closed, and the initial margin is forfeited by the trader. This prevents the platform from taking on too much of the trader’s risks, and it prevents the trader from losing their entire account to a losing trade. Liquidation can be partial (closing part of the trade) or total (closing the entire trade).
Triggers for liquidation
In a leveraged long trade – for instance, using a perpetual swap on a platform like dYdX – the trader is anticipating an increase in the valuation of an asset, and the trade loses if the asset’s price decreases. Because the trader’s losses are magnified by leverage, their funds are more at risk of total loss the lower the asset drops. The opposite is true for a short trade.
So, the platform or broker sets a price level that triggers an automatic closing of the trade: the liquidation price. This is often displayed to the trader when taking their position, so they can appropriately manage their trade. In general, the liquidation price is directly related to the amount of leverage used in the position. For example, if a trader places a long trade on BTC using 5x leverage, the liquidation price would be much lower (requiring a bigger percentage drop in price) than if they had used 20x leverage.
Depending on the specific derivative product, rules for liquidation may be slightly different or handled variably by different brokers and platforms. Traders must remember that triggers for liquidation are ultimately set by these parties. That means the rules can change over time and in different market conditions.
Strategies to manage and mitigate liquidation risk
Traders must use extreme caution when trading with leverage, whether by using derivatives or other financial tools. The best way to avoid losing money on leveraged trades is to use leverage sparingly. Traders should also be aware of the liquidation price of their positions and then monitor price movements. This way, their initial margin is never put fully at risk of liquidation.
Perhaps the most effective way of avoiding liquidation is to use stop-loss orders, which allows a trader to set a price level at which a position is closed automatically. However, unlike the case of liquidation, the trader controls when this happens. Ideally, they set a level that is just above (in a long trade) or below (in a short trade) the liquidation price, creating a comfortable buffer. The stop-loss price should be set at a level at which the trader is comfortable taking a loss, which is often a percentage of their initial position.