You get liquidated in crypto when you have borrowed money from an exchange and the price moves against you. Here is how it works:
Say you want to buy 5 BTC but you only have enough to buy 1 BTC.
You are in luck my friend because it turns out many exchanges are willing to lend you money to buy the rest for an extortionate fee (anywhere between 22-44% on an annualized basis).
Let’s plug in some numbers to see how this could play out:
Say the market price of Bitcoin is $10,000; a nice round number.
And let’s assume you only have $10,000 on your account balance with the exchange.
Now, you could buy 1 BTC and wait and see what happens OR you could borrow $40,000 from the exchange and buy 5 BTC.
The cool thing about this is that if the price of BTC increases you magnify your winnings.
Say the price rises to $10,500.
Had you invested in 1 BTC you would have made +$500 but by investing in 5 you have now made a profit of $2,500 minus fees.
Why doesn’t everyone do that?
Because if the crypto market moves in the opposite direction it will magnify your losses.
If the price of BTC drops to $9,500 you would be -$500 in losses with 1 BTC but -$2,500 plus fees with 5 BTC.
But wait, you only put in 10 grand and now you are left with $7,500.
It’s not looking good.
Your original $10,000 is your initial margin.
But now your margin is down to $7,500.
If the price continues to drop you could go all the way to 0.
Sometimes you can even go negative in which case the exchange starts selling other assets you hold with them.
Exchanges even take our insurance for extreme situations where the remaining funds available are not enough to cover losses and you end up with a negative balance.
And that my friend is when you get liquidated. C’est la vie
You can end up with total liquidation where you lose everything or partial liquidation where you lose a sizeable chunk.
So how do you avoid getting liquidated? Read on to find out
How to Avoid Liquidation
Rule number one in avoiding getting liquidated: Don’t trade on margin.
Trading on margin is a massive rookie mistake.
It’s equivalent to sports betting or playing high stakes in a casino i.e. it’s highly risky and unlikely to benefit you.
I have seen many inexperienced people lose their money with margin trading including myself.
While you might FOMO into crypto hoping to get rich quickly that is completely the wrong attitude to bring to crypto trading.
Slow and steady is what wins the race.
Rule number two: If you have to do it do it right
There is a right way and a wrong way to do margin trading.
The wrong way is to invest all your money and take maximum leverage of 20 or 100x and hope for the best.
The right way entails a little more planning
- If you are clueless about crypto first learn about it. Don’t just buy something because someone on crypto Twitter said it’s going to be the next big thing.
- For each trade allocate a small portion of your trading funds. Usually, about 1% is good. You want to be patient zen guy and not wen lambo guy. You are aiming for frequent small losses counterbalanced by fewer significant wins.
- To cap potential losses place a stop-loss order. I will explain this in more detail below but in a nutshell, a stop-loss is an automated rule to sell early if the price starts going in the opposite direction of what you would like.
How to use a stop-loss to avoid liquidation
Continuing with our example say you avoid the advice on this site and are hell-bent on buying Bitcoin on leverage.
Once you place your margin trade, place another order called a stop-loss order.
You will find this option in the drop-down menu of most crypto exchanges. It’s also known as a stop-order or stop-market order.
Once selected you will need to enter a stop price.
If Bitcoin reaches your stop price the exchange will instruct itself to place a market order for your leveraged assets and sell them at the going rate.
In our example, we saw how you would lose $2,500 if the price dropped by 5%.
In my opinion, letting the price slide by more than that is extremely risky.
Think of it: if the price of a digital asset is on a downward trend it ain’t coming back up soon enough to save you.
In such situations, it’s better to cut your losses and accept defeat. Hope is not a strategy.
A good rule of thumb is to be willing to accept a maximum of 1-1.5% of your total trading funds.
Let’s look at an example
If you only had $10,000 in your account with the exchange you would only want to leverage trade $100 at most.
Next, don’t be greedy and go for 20x leverage. Instead, opt for say 2 or 3 x leverage. Let’s assume 3x.
Following our rule of thumb, you should be willing to accept a maximum loss of 1%*10,000=$100.
But that’s all your margin. So don’t do that.
Set your stop loss at 5-10% below the current price instead.
Strategies to reduce liquidation exposure
Once you have placed your trade you are going to keep looking at your phone, I guarantee it.
The problem is, even though crypto is volatile, it’s not going to move that fast. Sure, you’ve got yourself a safety net with the stop-loss order which is good.
But you are going to need to sleep.
So you need to find a way to lock in your profits and exit the trade if things go well while you are away from a screen.
You don’t want the price to go up overnight only to find it has come back down in the morning.
Plus, the longer you stay exposed to the loan the more fees you will pay. For example, Kraken charges you fees every 4 hours.
Here’s what you need to do:
How to take profit
- Set a limit order to sell when the price increases by a certain percentage. In our example, I would be pretty happy if the price increased by 10% so I can set a sell limit order with a limit price of $10,100 which will instruct the exchange to sell my BTC if the price is $10,100 or higher
- Another alternative is to set a type of stop order called a take-profit order. It’s very similar to the example above except it sets a market order whenever the asset reaches a given stop price.
- If available you can also set a trailing stop. Who knows if the price will stop rising after it increases by 10%? It could go to +30% before it comes back down. A trailing stop loss allows you to follow the trend until it dips back down again. I explain how to set trailing stop losses in my post comparing a Binance limit vs. market order
How does a liquidation process play out?
When things start going south the exchange that has lent you the money will be sure to let you know via a margin call.
A margin call is a notification to top up your maintenance margin. If you don’t then the exchange can start closing your trading position.
Different exchanges have different margin requirements.
A margin ratio equals your maintenance margin divided by your account equity. In our example when the price of BTC dropped to $9,500 your margin ratio would be $7,500/10,000*100=75%
This would have likely triggered a margin call. For example, on Kraken, the margin call ratio is 80%.
The actual point at which forced liquidation happens also varies by trading platform and their liquidation mechanism.
For example, a 40% margin liquidation threshold would mean that the exchange will close all your positions when your margin ratio reaches 40%.
Liquidation price formula
When placing a trade it’s useful for you to know the price at which you get liquidated
Liquidation price = (Leverage – 1)*initial margin/No of tokens bought
For example, say I invest $4,000 and buy 20,000 tokens worth $1 by levering up 5x.
Then my liquidation price is:
Let’s do a final check.
When the price drops to 80 cents my profit/loss = tokens * new price- what I need to pay back my original investment
Profit/loss= 20,000*$0.8- 4*$4,000-$4,000=$16,000-$20,000=-$4,000.
To summarize, I invested $4,000 and lost $4,000 which means I got liquidated.
So the formula checks out.
Profit/loss margin calculator
When I trade on margin I like to plug in the profit/loss simulation into a calculator
I am going to share it with you here. All you need to do is make a copy (File>Make a copy) to use it.
Once you make a copy input your initial margin and leverage as well as the purchase price.
Then you can simulate what happens to your profit/loss by changing the exit price.
Voluntary liquidation vs. forced liquidation
A voluntary liquidation is when you liquidate yourself whereas a forced liquidation is when a trader’s position is closed by the exchange usually resulting in total liquidation.
Forced liquidations are accompanied by extra fees so that’s an added reason to avoid them.
What are the implications of multiple liquidations?
Now that you have understood liquidations it is helpful to think about the implications of what happens to a cryptocurrency market when many people trade on margin.
Imagine that we are in a bull market and because everyone wants to ride the wave they have overextended themselves and traded long positions on margin.
By the way, a long position is when you buy an asset hoping its price will go up
Now imagine that market conditions change and there is a small shock to the system that causes prices to drop slightly.
Some people hit their liquidation ratio and are forced to sell.
The selling pressure puts further downward pressure on prices.
This in turn causes further liquidations.
Cascading long liquidations exert a strong downward pressure on prices and the impact of the shock is magnified.
Of course, the opposite is also true for traders who are trading on margin with short positions.
A short position means you have the expectation that prices will drop in the future.
If prices continue to rise, short sellers are forced to buy as they get liquidated. As a result cascading short liquidations exert upward pressure on prices.
Liquidations such as these explain those sudden cliffs and spikes that you are familiar with in crypto.
What happens if I get liquidated crypto?
In the context of margin trading it means that your losses were magnified to such an extent that you lost some or all of the capital invested in the trade or more.
Do you lose all your money when you get liquidated?
No it depends on when you get liquidated. A partial liquidation will sting but you won't lose everything. A total liquidation will result in your losing everything you used for the position plus potentially more from your account balance with the exchange.
How do I not get liquidated crypto?
To avoid getting liquidated the best thing you can do is to avoid margin trading. The second best thing is to use limit orders or stop loss orders to cut your losses in case the price moves against you.
Should I sell my crypto for a loss?
Smart traders accept frequent small losses for fewer outsized wins.
Can you lose more than you invest crypto?
When you trade on margin your total crypto assets on the exchange may be liable for a margin liquidation. For example if you traded $100 on margin but you need to pay back $120 that extra $20 might come from the forced sale of other assets you hold on the exchange. You won't be allowed to place margin trades for which is you do not hold enough assets. Make sure to read the small print of the exchanges that you trade on margin with as each has slightly differing rules.
What is crypto liquidation fee?
When a crypto exchange is forced to liquidate your margin you pay an additional penalty fee usually about 1-3% in order to disincentivize you from ending up in that position.
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Cost basis refers to the original value of a cryptocurrency, such as Bitcoin or Ethereum, for tax purposes. It is crucial for accurately calculating capital gains or losses when you trade your digital assets. In this post, I will walk you through all you need to know about cost basis and its implications for calculating your crypto taxes. Read more.