Due to the crypto market volatility, traders implement the leverage strategy to maintain a position for a longer time and earn a substantial profit. However, traders may eventually face liquidation when they lack the funds to keep the leveraged position open.
Sometimes, investors involuntarily sell their assets in exchange for cash or stablecoins due to the inability to meet margin calls. This situation is also known as forced liquidation. Unfortunately, a trading position with high leverage is more exposed to forced liquidation and vice versa.
To maintain their positions despite the high volatility rate of cryptocurrency, informed investors implement the right strategies. Thus, this piece aims to enlighten readers about the mechanism behind forced liquidation and strategies that have proven to work.
Understanding Liquidation in the Volatile Crypto Market
Liquidation happens when an investor can no longer retain their leverage position. What does leverage mean? Leverage in crypto means traders are borrowing funds to buy a crypto asset with a potentially high ROI. The downside of leverage is that traders are at a significant loss if the investment fails. Thus, they are sometimes advised by their portfolio manager to exchange their assets for funds to rebalance the investment portfolio.
Also, an exchange may shut down a trader’s leveraged position. This happens when the asset keeps devaluing, especially below the liquidation price. This brings us to the two major types of crypto liquidation: partial liquidation and full liquidation.
Partial liquidation
This type is implemented to prevent borrowers and lenders from running at a great loss. In this case, the trader chooses to sell off a portion of their cryptocurrency asset. However, the rules involved in partial liquidation may vary, so traders must understand the terms and conditions of their margin trading before liquidating their assets.
Full liquidation
In the case of full liquidation also known as total liquidation, the trader’s margin is exhausted, and the exchange is forced to sell assets to cover outstanding debts. Traders who use their crypto holdings as collateral may also face this type of liquidation.
Mechanisms Behind Forced Liquidations
The two major mechanisms behind forced liquidation are margin calls and leverage. As mentioned earlier, leverage amplifies risk, which exposes traders to liquidation, but how does this happen?
Foremost, leveraging assets expose traders to great risks. For instance, a trader leverages x5 with an initial capital of $1, which means the investment is now five times the initial risk. Even the smallest fluctuation or unfavorable market movement can create a magnitude shift toward loss.
Before an exchange liquidates a trader’s asset, you may be asked to deposit more money into your investment portfolio to maintain your position. In all these, there is also a term known as “maintenance margin,” which triggers margin calls.
A trader is required to deposit an initial margin, which serves as a form of collateral for potential trading loss. In response to this, the trading platform will set a maintenance margin. Thus, a margin call will be triggered if the trader’s account value is less than the maintenance margin set by the trading platform.
Case Study: Examples of Forced Liquidations
This section will give two examples of forced liquidations: The Bitcoin Flash Crash and The GameStop Short Squeeze.
Bitcoin Flash Crash
In 2021, bitcoin experienced a sharp price decline of about 87% on Binance, which caused up to $300 billion loss in less than 24 hours. According to CoinDesk, Bitcoin sharply fell from $65,760 to $8,200 and rose again, which was caused by a bug in the trading system. It’s quite unfortunate that this incident forced many investors into liquidation.
The GameStop Short Squeeze
When COVID-19 broke out, the GameStop share dropped by 50%, which caused investors to panic, predicting that the company may close down. However, some investors were convinced the company had a strong foundation and wouldn’t fail as predicted, so they bet the stock price would rise. Unfortunately, a squeeze eventually happened, forcing investors to lose billions of dollars in hedge funds, especially for short position holders.
Strategies to Avoid Getting Liquidated
With the right strategy, crypto traders can avoid getting liquidated despite the high rate of market volatility.
Develop a Trading Plan
Developing a trading plan ensures market circumstances do not hit you unaware. It also reduces the possibility of making errors due to impulsive or emotional trading habits. One of the ways to develop a trading plan is to set a stop-loss order. You can automatically sell your asset if the price rises above the predetermined level.
Draft a Risk and Money Management Strategy
Your trading plan will be ineffective if it lacks the right risk and money management strategy. One of the ways to manage your risk is to limit your exposure level. You can incorporate a general rule of not investing more than 1-2% of your crypto asset.
Secure Your Trading Positions
To avoid getting liquidated, set an exit plan that will work to your advantage whenever the market moves in an unfavorable direction. Thus, pay attention to the stop-loss order and make necessary adjustments.
Avoid Compounding Losses
Seasoned traders often compound losses intending to boost their gains or profit. However, this may eventually cause them to lose money in the long run. Thus, traders should cut out lost positions instead of attempting to increase the average entry price on such positions.
Maintain Sufficient Margin
Some traders make the mistake of investing their margins in a single trade. Have a sufficient amount in your account to keep your maintenance margin open. The higher your margin balance, the lower the possibility of liquidating.
Continuously Educate Yourself
As years pass, new crypto projects are launched into the community, which may influence the price of certain crypto assets. As a result, investors must stay informed and updated on current news and events. This should also include the ongoing activities in your chosen trading platform.
For instance, traders on the Solus Finance platform should be interested in knowing about the platform’s collaborations, including the latest one with Earn Network. In a recent tweet, Solus Finance emphasized how its latest collaboration is meant to provide staking opportunities in the world of DeFi via the tweet below.
Earn Network partners with Solus Finance 🙌
An exciting collaboration with @solusfinance as we venture into joint staking opportunities in the world of #DeFi 🌐
💎 Stay tuned for upcoming token staking and NFT rewards! 🚀#EarnNetwork #SolusFinancehttps://t.co/BNb1bFmLkT
— Earn Network (@itsearnnetwork) November 4, 2023Here is what the web3 expert Ajeet Khurana says about Solus Finance’s innovative projects.
Early adopters are already Web3-enabled, but to onboard the next billion, we need applications that are easy and engaging. That’s what Solus is doing. And the results are showing:
100000+ transactions
50000+ active users
500+ transaction per day
100+ active users per min
The new wave of Web3 has attracted the best talent. I was privileged to talk to @dey_sanghita, former Head of Product at Western Union, and now founder of hot new Web3 project: @SolusFinance
Early adopters are already Web3-enabled, but to onboard the next billion, we need… pic.twitter.com/PDNZ6Vr0Bs
— Ajeet Khurana REFLEXICAL ⭕️ (@AjeetK) October 26, 2023Conclusion
Most traders fear liquidation, so they always endeavor to stay ahead of the market. From developing a trading plan to avoiding compounding losses, informed traders implement the right strategies to prevent trading losses. Also, acquiring the right trading knowledge assists investors in leveraging and meeting the required margin call for a successful trading experience.
