When crypto markets are volatile, a sharp eye can spot quite often the word “liquidated” in most of the headlines. The term is used to refer to an event that occurs when traders/investors (used interchangeably) cannot margin requirements for their leveraged position. Given the amount of value crypto assets lost in the past few months, liquidations were on the horizon but what surprised everyone was firms like 3AC (3 Arrow Capital) who were considered “too big to fail” were forcefully liquidated. In today’s article, we will try to understand what liquidation means, why some investors utilize high-risk strategies like margin trading and when they are forcefully liquidated.
Liquidation refers to the activity of selling off crypto assets for cash to mitigate losses in the event of a market crash. However, in the crypto world, the term liquidation is mainly used to describe the forced closing of a trader’s position due to the partial or total loss of the trader’s initial margin. This happens when investors do not have sufficient funds to keep the trade open. Let’s address in detail what terms like margin, leverage means before going any further.
Crypto margin trading is the process of borrowing money (typically from a crypto exchange) to trade a higher volume of assets. This method can provide the trader with increased buying power (or leverage) and the potential for greater profits. Of course, it comes with severe implications.
Let’s look at it with an example. To open a trading position in margin trading, the exchange will require a trader to put forth a certain amount of crypto or fiat currency (also known as the “initial margin”) as collateral. These funds help to insure the lender against loss if the trade goes south.
Leverage is calculated using the amount of funds a trader can borrow from an exchange relative to your initial margin. If a trader starts with an initial margin of INR 1,000 and 10x leverage, that means you’ve borrowed INR 9,000 to increase your trading position from INR 1,000 to INR 10,000. So if the asset's price rises by 5%, the trader would have gained INR 500 (or 5% of INR 10,000) from the initial trading position. That is, with just a 5% price increase, the trader has netted a profit of 50% of your initial INR 1,000. Sounds great, right? No wonder why institutions like 3AC entered such trades.
But crypto is highly volatile, and the price of an asset could tumble in a matter of minutes. So continuing with the example above, with a 5% drop in your asset’s price, you’ve lost INR 500, or 50% of your initial margin, which translates to a 50% loss.
Liquidation happens when an exchange closes out a trader’s position because it can no longer meet margin requirements. Margin is the percentage of the total trade value that must be deposited with the exchange to open and maintain a position.
When a trader’s margin account falls below a level previously agreed upon with the exchange, positions will automatically start liquidating. When leveraged position reaches the liquidation threshold, traders will face a “margin call,” which means they have to add more funds in order to increase margin.
Continuing with the above example, let’s say the asset (Bitcoin) trader is trading on slipped by 10%. Trader’s position now is worth INR 9,000. To avoid losses to the borrowed capital, the exchange would then liquidate the trader's position to protect the money lent to the trader. The position is forcibly closed and with it, the trader's initial capital of INR 1,000 is also lost.
The main takeaway is that higher leverage has the potential to make more money when the trade goes well, but only requires a small negative price movement to trigger a liquidation event. For instance, a trade position with 50x leverage will only take a price slide of 2% to initiate a liquidation.
Naturally, we advise you not to take leverage to trade - trading is not profitable for 90% of traders and hence there is always a risk of you losing your portfolio value by using leverage.
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Disclaimer: This article was authored by Giottus Crypto Exchange as a part of a paid partnership with The News Minute. Crypto-asset or cryptocurrency investments are subject to market risks such as volatility and have no guaranteed returns. Please do your own research before investing and seek independent legal/financial advice if you are unsure about the investments.