What is Liquidation in Cryptocurrency?
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What is Liquidation in Cryptocurrency?

written by John Murphy | November 25, 2022

Liquidation – the bogeyman of cryptocurrency trading. Volatility and crypto go hand-in-hand, thus making cryptos a prime target for Liquidation. But what is Liquidation in Cryptocurrency?

In simple words, Liquidation occurs when an investor has insufficient funds to keep a leveraged trade open. However, leverage allows investors to maximize potential gains and losses.

Cryptocurrency liquidation is one of the most unwanted situations faced by investors who opt for leveraging. It may appear the best strategy to mitigate price fluctuation risk, but it is equally prone to get investors in hot waters. You will face severe losses if the market is against your leveraged amount. 

Thus, Liquidation becomes an essential point of concern when investing in cryptocurrencies. Through this article, we will delve into developing a sense of liquidation, how to evade it and how to act if it happens. We will also look at why cryptocurrencies are more prone to liquidation.

So, let’s get started!

Understanding Crypto Liquidation

Liquidation is the ability to turn an asset into cash. In the crypto environment, liquidation is selling off crypto assets for cash to avoid or minimize losses wildly when the market is crashing. It happens when a crypto trader fails to have funds to keep the trade open.

In technical terms, when a trader’s leveraged position is compromised due to the price going down. Since the margin is insufficient to cover the losses, the exchange is forced to close the leverage automatically. That’s called Liquidation.

Liquidation has two types – partial or total.

  • Partial Liquidation is the part closure early on to reduce the leverage used by the trader. It is closed before the entire margin is used; it prevents complete loss and depends on the agreement between the exchange and trader.
  • Total Liquidation is a complete closure of leverage used by the trader. In other words, if all the initial margin is used, the exchange will forcefully close the position. 

In addition, Liquidation is divided into forced Liquidation and Liquidation. However, practically speaking, the market jargon used is Liquidation.

How does Liquidation happen in Cryptocurrency? 

Let us understand cryptocurrency liquidation with the help of an example.

Imagine you entered the market with a 10x leverage facility and invested $1000; thus, the total assets on your disposal become $10,000 ( $1,000 of your money and $ 9,000 borrowed by exchange).

Let us assume Cryptocurrency slipped by 10%; your current position will be $9,000. Now, if the dip continues, your position’s losses will increase and apply to the borrowed funds. Subsequently, the exchange will freeze your place to avoid losses on borrowed capital. Thus, your position is closed – and you lose your investment of $1,000.

Further, this is not all, as the exchange will also charge you a liquidation fee. The purpose is to encourage traders to call their positions before they are liquidated proactively.

How to Avoid Crypto Liquidation?

It is almost impossible to offset liquidation risk in the cryptocurrency market utterly. High price inconsistencies increase the chances of Liquidation. Similarly, a high lever ratio leads to higher risks.

However, you can use different risk-evading strategies to minimize the impact of losses.

  • Stop loss strategy: Investors choose a specific price level to close the position to minimize the loss automatically. Stop loss strategy is a safety net to limit the damage.
  • Trailing stop-loss: It sets a maximum value or percentage of loss that can incur on a trade.
  • Insurance pool: It can help investors and crypto brokers to cover contract losses. The insurance pool will cover the loss if the liquidation price is higher than the initial margin.

In addition, you can stay vigilant to expected price drops and act accordingly to avoid liquidations. Financial has developed a formula that can help you know your leverage position.

Liquidation % = 100/Leverage.

For example, if you have 5x leverage, your position is liquidated if the price moves 20% against your position (100/5=20). So, keep an eye on price trends and act proactively before it gets too late.

Frequently Asked Questions

How can I liquidate Cryptocurrency?

You can liquidate Cryptocurrency by below steps:

  • Sell crypto using an exchange
  • Go with peer-to-peer trade
  • Cash-out Bitcoins through ATM
  • Trade less-known cryptos with Bitcoin or Ethereum and then cash out

Should I liquidate my crypto?

It entirely depends on your investment goals. However, if you are planning for a long-term relationship with the crypto market, there are better ideas than cashing out the entire investment.

When should I liquidate Cryptocurrency?

It is a prudent decision as far as returns are concerned. It would be best to have thorough market research and predicted price trends before liquidating crypto. If you have a leverage option and the crypto market is crashing, it is time to liquidate your digital assets.

Are there any extra charges the investor has to pay in case of Liquidation?

Few crypto brokers charge fees on top of losses made during price nose dives. It is set to safeguard the interest of the broker lending Cryptocurrency. In addition, the fee rate is mutually agreed upon by the exchange and investor.

Will I lose all my Cryptocurrency in case of Liquidation?

There are chances that you may lose your entire crypto assets; this is generally known as total Liquidation. 

Parting Thoughts

Liquidation of Cryptocurrency is an unwanted act that each investor would not praise to face. But, since the crypto market is highly volatile, and prices nose-dive now and then, it is inevitable that you may face Liquidation at any time.

However, acting innovative and proactive can save you from hefty losses. If you develop and implement the right strategies, you can mitigate liquidation risk. However, this requires intense market analysis and correctly predicting price trends.

Furthermore, before investing, you must learn what is Liquidation in Cryptocurrency so that you may develop ways to avoid it. For easy reference, Liquidation occurs when traders cannot fulfill the obligation imposed by leverage.

Despite multiple gain opportunities, leveraging is highly risky and can amplify losses. 

Please leave your comments and share your experience if you encounter a liquidation issue. Adios and best of luck!