How to Not Get Rekt — Understanding Liquidations in Crypto Derivatives

Understand what is liquidation and how to avoid it

In the world of derivatives trading, there is a term that scares even the most sophisticated trader — liquidation.

In this article, we’ll explain to you what “liquidation” means, why it’s so scary, and how you can avoid it.

But first, we need to understand why liquidation needs to exist. 

When people trade on a derivatives exchange, they can use leverage to increase their buying or selling power. But we all know there is no such thing as a free lunch (maybe only free airdrops?). So who gives the extra buying/selling power to a leveraged trader and what’s in it for them? The answer is the exchange—the exchange offers this service so that they can collect more transaction fees. However, as an exchange operator, there is a balance that needs to be struck.

You see, an exchange operator can let users trade with super high leverage, like 100x leverage. But in a volatile market, the exchange might not have enough time to close a position before the net value of a leveraged position goes sub-zero. 

For instance, assume ETH is currently traded at 4,000 USDC and a trader uses 10 USDC as the collateral to open a 0.25 ETH long position, meaning that this trader uses 100x leverage (use 10 USDC to trade 1,000 USDC). But what happens if the price of ETH suddenly drops to 3,800 USDC in the next split second?

→ From the exchange operator’s perspective:

This sudden drop creates a loss of 40 USDC ((3,800-4,000)*0.25 - 10 (the original collateral)) for the exchange. This is the reason why liquidations exist—they let the exchange close a trader’s position before it goes bankrupt and hence prevents the exchange from losing money. Further, in the volatile crypto space, exchanges usually won’t allow leverage like 100x, because the higher the leverage, the less time the exchange has to close a position.

→ From the trader’s perspective:

You lose the 10 USDC you put in because your position gets automatically closed (or “liquidated”) by the exchange. To put it differently, when your position gets liquidated, you lose the amount of money you put in a position. (While we’ve simplified the example above, most exchanges including Perpetual Protocol use a system of ‘fair’ or partial liquidations to return funds to traders or keep traders’ positions open when possible.)

So why would traders use leverage, given the risk of liquidation? Aren’t they play with fire? Well, as you can see in our example above, the trader was able to use 10 USDC to buy a large amount of ETH. Their gamble did not pay off, but if it did, they would have earned a large profit, while only risking 10 USDC.

So as a trader, how can we avoid our position getting liquidated?

  1. Understand the liquidation rules on the exchange before trading
    Each exchange has its own rules when it comes to liquidation. Sometimes, an individual market on an exchange has its own liquidation rules. So it’s better to check the rules before trading.
  2. Don’t use too much leverage
    I know, I know. It sounds exciting to trade with more money than you have. But the higher the leverage you use, the more likely your position gets liquidated. A leverage of 2 to 3X to trade with should be a good starter*. 
  3. Don’t open short positions
    We all have seen the price of a token shoot up 100% in a day for no good reason. Because of this, if you aren’t familiar with a token (or know what you’re doing), it is best to stay away from opening a short position as a beginner trader.
  4. Learn how to use stop-loss orders
    Besides the typical market order and limit order, it’s essential to learn how to use other advanced order types, such as stop-loss orders, to cut losses when the price movement goes against you. 

*Please note that this is not investment advice. Please do your own research and make your own investment decisions according to your risk appetite. Never trade more than you can afford to lose.