The volatility of the crypto market is the core factor enabling it to have margin opportunities. Fairly, it is the one revoking equally proportional risks.
Some give the writing on the wall, while others can unfold rapidly, with no hints before wiping out a balance.
Today’s article is diving into one of the most common and yet scariest threats in the market, which tends to occur abruptly – liquidations. Awareness is everything – and this piece is set to contribute to it.
What lies behind the reasons for liquidations, how to take precautions against them, and why they are the essence of leveraged trading – below.
While for spot traders volatility is seen as a blocker, it is what leverage traders mostly rely upon. The market swings have long become a mere basis for such investors, allowing them either to open a long position or a short position – respectively predict prices’ hike or descent.
However volatile the market is, its short-term shifts do not tend to make a great difference and, hence, they do not ensure a compelling margin within a set leading trend.
It is when artificially raising the stakes comes in handy. To increase gross revenue from a trade, market participants have an opportunity to borrow the funds from the exchange, proportionally enhancing a potential profit. This method sought its implementation in margin and futures trading, and the amount of the borrowed funds is referred to as “leverage”.
Within both types of leverage trading, the borrowed budget opens a door to proportionally higher returns. The only condition to maintain – follow the trend.
Slight price fluctuations against the position don’t always result in the loss. As the shortage of funds to maintain the order appears, the trader will always receive a margin call – a request for adding the funds to meet minimum capital requirements. On some of the exchanges, like Coinbase or WhiteBIT, even auto investment mode is available to preset the orders and diminish such risks.
Nevertheless, short-term swings don’t always have to be slight. Sometimes, the market can move against a leveraged position so intensively that the losses can multiply as fast as potential gains.
Such disbalance between the leveraged order size and market rate tends to end with a liquidation of position – an automatic closure of positions.
The positions are subordinated for closure only when reached a predetermined, liquidation level.
The liquidation level is a risk management tool brokers and exchanges use to protect themselves and the clients from the potentially devastating effects of leveraged trading.
In a nutshell, if the market moves against your positions and the amount in your trading account falls below the maintenance margin required, only then you might reach the liquidation level and have your positions closed.
The core reason why liquidations are feared is their association with something uncontrollable, insubordinate to investors’ intervention. But how true is that belief?
The truth is – you never know the exact point of a market setback.
The market can be negatively affected by a range of factors beyond investors’ control – from recessing tendencies in the key global economies to international conflicts breakout.
However, the genuine origin of market fluctuations lies not in the factors, but the investors’ reactions to them. The effect from the external events is brought up with the next steps a majority of investors take. Whether it is extreme greed, or a rampant fear that forces uncontrollable sellings – in the end, there are traders’ actions which form the invisible hand.
“The market acts as a mirror, which will always reflect you and your level of understanding and emotions on the chart,” believes Bryan, a renowned market analyst and day trader with DEX-managing background. According to him, even the mass liquidations are caused merely by the reflection, but not action as it is.
“Most new traders get liquidated simply because they underestimate this beast. They may get lucky on one or two trades, and blinding greed takes over to the point where the trader thinks they’re invincible”.
It becomes clearer when analysing the largest mass liquidations in the crypto market history.
One of the latest chain of liquidations has become the inevitable result of enthusiasm spark against of a so-called “Uptober” – a month in which cryptocurrency market was predicted to thrive. Traders’ hopium brought down long positions estimated at over $500 million just in 24 hours, going against massive positive buzz and greed.
Thus, the informational sentiment plays a decisive role in the market, while immediate affection by it becomes a dangerous play. Such a tendency occurred prior to Bitcoin exchange-traded funds (ETFs) listings, when U.S. Securities and Exchange (SEC) Commission’s denied a previously-released statement from the official X account, confirming ETFs approval. This resulted in $220 million-worth liquidated positions, opened following the positive update.
However, not always does the market end up playing itself – many mass liquidations become an eventual consequence of external threats. Case in point: August 2, 2024, when geopolitical tensions in the Middle East and struggles in Big Tech sector’s revenues unexpectedly crashed the market and left traders with over $1 billion-worth liquidated positions.
Similar tendency was spotted amid the beginning of Russia’s full-scale invasion into Ukraine and HAMAS’ October 7th attack on Israel.
As high-volume market fluctuations are often followed by the circumstances of force majeure, it may seem that liquidations’ risks are unavoidable. However plausible this may sound, there is a different side to this matter.
The factors causing market fluctuations, while factually provoked by investors’ behaviour, can not be prevented by the traders’, going against market trends. However, this does not mean that the precautions can not be taken in advance.
At starters, the risks of being trapped by position’s liquidation can be estimated within the liquidation level your exchange or broker puts. Calculating your potential profits and possible losses in advance is one of the dead simple yet robust precautions a trader can take against danger of liquidation. This also includes setting up a proper leverage, relevant for the budget you are ready to risk.
“The key to leverage is not seeing it as ‘look how big of a position I can open,” stresses out Bryan. “It’s all relative to your collateral”.
The initial strategy matters the most. Upon your leverage and estimates, it is vital to set a clear target to the position opening. “If you don’t have a set target prior to the position opening, then you have no chance against a volatile market,” says Bryan.
While predefined strategy is the essence, this does not mean that the things will not get out of the trader's hand, seeing the market’s volatility. However, this also does not put a trader with no options.
“The biggest warning sign (for liquidation) is when a trader goes in with a one-sided bias; has no plan if the trade goes against them,” states Bryan.
Flexibility plays a crucial role in risk management; the ability to adapt strategy and alter the position, even if it costs a potential profit, can become a lifesaving rule of thumb.
“Do not add to a losing position, regardless of how tempting it is,” warns Bryan. “You were wrong for a reason initially, there’s no point in adding more in hopes it turns around”.
According to Bryan, in the end, it is discipline and right mentality what matters in leveraged trading:
“The best tool any trader can have is discipline and patience. Without these two virtues, the market will seem impossible and “out to get you”. It doesn’t matter how long you trade and how successful you are – there will absolutely come a day where you have to stare at a stop-loss and lose trade in the face”.
Liquidation is a fearful term, and it is difficult to believe otherwise.
But in reality, liquidation is less of a threat and more of a built-in safety net, designed to protect both the trader and the wider financial ecosystem. Think of it as a fail-safe mechanism that kicks in when things go south, ensuring that losses don’t spiral out of control.
Beyond that, liquidation is a great equalizer. Without liquidation, traders could lose more than their initial investment, and exchanges could be left holding unpayable debts, leading to systemic risks.
“Liquidations are an essential tool to the trading system because it’s how other traders are paid,” says Bryan. “Now there are obviously market makers who supply both sides of the market to ensure traders can go long and short as they see fit, but in order for a trader to make a $30k profit, there needs to be traders somewhere taking a $30k loss”.
Crucially, by enforcing a limit to how much can be lost, liquidations safeguard capital, prevent market chaos, and ultimately ensure a smoother trading environment.
In this light, it’s not a monster to be feared but a toolkit for maintaining security, stability, and fairness in the market; and an integral part of traders’ experience, which, when completed, opens a door for the new high, according to Bryan.
“It’s not an easy path, but the person you’ll become is worth more than any dollar you’ll ever make in the market”.
Originally published on 36crypto.com on November 19, 2024
Paul Osadchuk
