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Crypto Leverage & Liquidation

By Dan Mulligan | AUG 24, 2022

Crypto Leverage & Liquidation 5:22 Min Read

Crypto Leverage & Liquidation

With the cryptocurrency market still being at a nascent stage, lots of fluctuation is commonplace. Even Bitcoin, Ethereum, and some of the largest coins are subject to heavy price swings. While the volatility presents an opportunity for investors to generate significant returns compared to traditional asset classes (such as stocks and commodities), it also presents a higher risk. With traders routinely trading through margin using derivatives such as futures, options, and perpetual swaps – liquidations can be common. For instance, when Bitcoin fell below $43,000 in January, more than 200,000 customers saw their positions liquidated for a total exposure of $800 million. 

Understanding Leverage & Liquidation 

Cryptocurrency traders looking to grow their financial gains usually tend to employ leverage through derivatives and other margin-based products. To borrow money from a crypto exchange, traders need to first put up money through crypto/fiat. This is known as the initial margin. Depending on the level of leverage, each transaction has the potential to gain or lose more money. For instance, if a trader would need to initiate a position in Bitcoin of $1,000 and the exchange offers 10x leverage, they would need to deposit an initial margin of $100. In this case, if the price of Bitcoin rises by 3%, the trader would make a $30 profit on the $1000 trading position, implying a 30% profit on the initial capital of $100. While the opportunity to attain larger returns can drive traders to employ more leverage, margin trading can lead to huge losses and, in some cases, can also result in the liquidation of a position.

Liquidation is when a trader’s position is closed due to a partial or total loss of the initial margin. This happens when a trader cannot meet the margin requirements for a leveraged position due to insufficient margin, despite being issued a margin call. To understand liquidation, let’s use the example from above. In this case, the trader has a margin account net value of $10, with the minimum maintenance margin of $70 required to maintain the position. If the trader’s Bitcoin position price falls by 4%, the account value falls to $60 (due to the 10x leverage used earlier). This triggers a margin call. If the trader fails to respond to the call, the exchange has the right to liquidate the Bitcoin position to reduce the leverage. With leverage being a double-edged sword, traders should employ risk mitigation strategies to avoid liquidation.

Using A Stop Loss

The core idea behind risk management is to minimize the risk of outsized losses. One way to do this is with a stop-loss order. This essentially lets a trader set a limit on the loss that is accumulated before automatically exiting the position. Taking the example from above: if the trader sets a stop-loss at 2% of the trade size, their Bitcoin position will automatically be closed out if the price falls by 2%. Thereby preventing a margin call and the risk of liquidating the trade while leaving the trader with $80 for future trades. Thus, when traders use stop-loss orders, they sell their shares at a predetermined price and can avoid the common mistake of letting their emotions get the better of them mid-trade.

Implementing the 1% Risk Rule 

The 1% risk rule is a strategy employed when a trader uses a stop-loss on each trade equivalent to the maximum value of 1% of the account. The 1% risk rule helps limit the risk of each trade and protects against significant declines during unfavorable trades. For instance, if a trader has $100 in their account, they won’t risk more than $1 capital on a single transaction. Thus, a trader would need to lose 100 trades successively to wipe out their account, significantly bringing down the risk of liquidation. The rule can be tweaked based on the account size, prevailing volatility, and the level of comfort and experience displayed by the trade. The rule of thumb to trade volatile assets is to risk 1-5% of capital.

Using an Exit Strategy 

Identifying key price support and resistance levels, as well as mapping out trades ahead of time, is key to mitigating liquidation risk over the long term. An exit strategy implies that a trader understands the risk-to-reward ratio of the position initiated while setting targets to take profits at key levels. There are several exit strategies, including dollar-cost average, exiting based on achieving price targets, and the percentage returns estimated ahead of the trade.

Reducing Leverage  

While using leverage can help significantly boost returns, it can also equally lead to large losses. Using the right amount of leverage can help you stay in control of your trades. As seen in the above example, a large level of leverage can harm a trader even when a minor price change happens. As a result, utilizing less leverage can help a trader navigate a turbulent cryptocurrency market more smoothly and securely.

Avoiding Overtrading

Overtrading happens when a trader has too many open positions or is ready to risk a disproportionate amount of cash on a single deal., [1] This puts their whole portfolio in danger. New traders are especially prone to overtrading by letting their emotions get the better of them. To avoid accumulating devastating losses, traders need to prudently manage their capital and manage the cumulative risk of the portfolio (the sum of risk on all active trades in the account).

Bottom Line 

Trading cryptocurrency derivatives can be highly lucrative, especially considering the high leverage that it tends to provide. However, traders can also suffer significant losses and risk seeing their portfolio liquidated. 

Frequently Asked Questions

What is liquidity risk?

Liquidity risk is when an asset cannot be converted into cash quickly enough without incurring a loss due to a lack of interest in this said asset. Something that commonly happens during large price actions that provoke liquidations.

How to manage liquidity risk?

The simplest way to manage liquidity risk is to have enough cash/liquid assets on hand to pay short-term debt obligations.

How to hedge liquidity risk?

An investor can hedge liquidity risk by attaining more assets that can generate cash flow independent of a risky asset’s price movements. A diversified portfolio.

What are the risks of liquidity pools?

The main risk of a liquidity pool is the dreaded impermanent loss. It is a temporary loss of tokens when providing liquidity in a pool during price action between two AMM assets as opposed to simply holding the assets in a wallet. The loss becomes permanent when the assets are withdrawn from the liquidity pool.


Author: Dan Mulligan

SaaS marketer, trader of internet coins, tech enthusiast, and home chef. Buildooor of Tidus Wallet and current Marketing Director at AscendEX. Dan enjoys crypto twitter, market volatility, anime, and paid ads. Key accomplishments: - 5th Grade Readers are Leaders Winner - 2-0 Amateur Boxing Record - Former Overwatch Grandmaster

Education: B.A & MBA - Marketing Communications

Crypto Class of: 2016/17

Fun Fact: Served Method man and Red man ice cream from 2004-2009



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