What is Liquidation
Liquidation is the process by which an exchange or margin trading platform forcibly closes a trader's position. When the trader's losses on their leveraged position exceed the collateral or margin they provided when opening the position, the exchange automatically sells the trader's assets to cover their position, known as forced liquidation, which protects the trader from further losses (you might be confused, but don't worry, I will explain later).
Different Forms of Liquidation
To be more specific, there are two main types of liquidation: partial liquidation and total liquidation.
Partial liquidation generally occurs early before the initial margin is depleted. As the name suggests, partial liquidation only closes a portion of the position to cover the losses and maintain the required margin level. In this case, if the price of the cryptocurrency becomes favorable to the trader, this may offset their losses. However, if the price continues to move against them, it also exposes the trader to greater risk.
Total liquidation is more direct, where the exchange forcibly closes the entire position to prevent further losses. However, this may also be unfavorable as traders miss opportunities to offset their losses.
Positive Effect of Liquidation
Now let's explain why "forced liquidation can protect traders."
In extreme market conditions, traders may lose all their margins quickly. If the exchange does not liquidate the trader's account immediately, the trader will continue to "lose money," and their account balance will become negative.
At this point, the trader will not only be unable to recover their margin but will also owe the exchange money. The exchange will also be concerned about the loss being irreparable if the trader does not repay the debt. Although insurance measures can reduce such risks, this is undoubtedly something that no one wants to see. Therefore, forced liquidation can "protect" the rights and interests of traders to some extent.
How Is Liquidation Price Calculated
The liquidation price calculation depends on several factors, including the trader's leverage, entry price, position size, and maintenance margin rate. Here's a general formula to calculate the liquidation price for a long and short position in a perpetual contract:
- For a long position: Liquidation Price = Entry Price / (1 + (Initial Margin - Maintenance Margin) / Position Size)
- For a short position: Liquidation Price = Entry Price / (1 - (Initial Margin - Maintenance Margin) / Position Size)
- Entry Price: The price at which the trader entered the position.
- Initial Margin: The percentage of collateral required to open the position, usually calculated as (1 / Leverage).
- Maintenance Margin: The minimum percentage of collateral required to keep the position open.
- Position Size: The size of the position, usually expressed in terms of the contract's base asset.
Kindly note that this formula is a simplification, and in practice, exchanges might use more complex calculations considering factors like funding rates, fees, and additional margin requirements. And keep in mind that different exchanges might use slightly different formulas or include additional factors, so it's essential to understand the specific exchange's methodology.
Although calculating liquidation prices can be cumbersome, the good news is that often we don't need to calculate them manually. Most centralized exchanges will display your liquidation price and the probability of liquidation on your holding interface. In addition, some exchanges also provide liquidation price calculators. Take Binance as an example:
On the perpetual trading interface, you only need to click on the calculator and select "Liquidation Price," then enter the leverage, entry price, and quantity to calculate the corresponding liquidation price. The whole process is very convenient.
Mechanism and Fees of Liquidation
Let's take a long position as an example to explain how liquidation occurs. Suppose your initial margin is $100, and you open a 10x leveraged position on BTC, which means you borrowed $900, and your total position is $1,000. If the price of BTC rises by 10%, you will earn a profit of $100 from the trading position. If you do not use leverage, your profit will only be $10, and leverage amplifies your profit.
If the price of BTC drops by 10%, your position value will be $900. If the drop continues to increase, it will affect the borrowed funds. To avoid losses on the borrowed funds, the exchange will subsequently liquidate your position to protect the funds lent to you. If you do not add more margin before this happens, you will be forced to close your position and lose all your initial margin.
It is worth noting that forced liquidation usually incurs additional liquidation fees, mainly to encourage traders to close their positions manually before liquidation. In practical terms, considering the issue of liquidation fees, your account will likely be liquidated when the price of BTC drops by only 9.5%.
Therefore, traders must manage their risk carefully when trading on margin and maintain sufficient margin levels to avoid liquidation.
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