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What is liquidation on exchanges? How do they lose millions on Bitcoin surges?

When there are sharp fluctuations in the exchange rate of cryptocurrencies, analytical services record the liquidation of traders’ positions worth hundreds of millions of dollars. CEO of the ASTL investment project Andrzej Korotkiewicz explains how it works and how to minimize risks when trading with leverage.

Cryptocurrency exchanges give traders the opportunity to increase the size of their trading positions through the use of derivative products such as margin trading, perpetual swaps or futures. The first cryptocurrency derivatives appeared back in 2011 and have gained popularity over time, especially among retail traders looking to get the most out of their trades on exchanges. Binance, Bybit or OKX are examples of cryptocurrency exchanges that allow clients to trade cryptocurrencies and cryptocurrency derivatives with leverage. In so-called margin trading, borrowing funds from an exchange to build up trading positions can increase a trader’s potential profit, but the risk of losing invested capital also increases.

There are analytical tools that can track data about cryptocurrency exchange wallets and the transactions of their users, so services like Coinglass or numerous bots in X or Telegram can monitor data on liquidations of margin positions on large trading platforms in real time. Thus, according to Coinglass, from December 11 to December 12, 2023, when the Bitcoin rate fell by more than $3 thousand and provoked a fall in the price of other crypto assets, traders’ positions totaling about $0.5 billion were forcibly closed. Most of the liquidated traders were long-term positions, that is, they bet on a further increase in the price of Bitcoin or other cryptocurrencies.

Margin trading involves increasing the amount allocated for a transaction by attracting third-party funds from the exchange. This allows investors to increase the size of their trading positions using leverage. In order to open a margin trading position, the exchange requires a certain amount of cryptocurrency or fiat funds to be deposited as collateral – the so-called “initial margin”. This collateral acts as insurance for the exchange in case the transaction goes against the borrower. The amount that can be borrowed from the exchange in relation to the initial margin is determined by the amount of leverage. For example, with 5x leverage and an initial margin of $100, to increase a trading position from $100 to $500, a trader borrows $400 from the exchange.

Each trade can generate more profit or loss depending on the amount of leverage. For example, if the price of an asset rises by 10%, the trader will make a profit of $50 on a $500 trading position, which is a 50% profit on the initial margin of $100. The trader will then repay the $400 loan and keep $150 ($50 profit + $100 initial margin). But if the value of the asset falls by 10%, the trader will lose $50 of his initial margin, that is, he will receive a 50% loss. There is a formula for calculating the potential profit or loss when using leverage: Profit or Loss = (Initial Margin) x (Percentage of Price Change) x (Leverage).

In the context of cryptocurrency markets, liquidation means that an exchange forcibly closes a leveraged trader’s position due to a partial or complete loss of his initial margin. This occurs when a trader is unable to meet the margin requirements for a leveraged position, meaning they do not have sufficient funds to maintain an open trade. Liquidation occurs in both margin and futures trading. Trading with leverage comes with a high risk of losing all of your collateral (initial margin) if the market moves far enough against the trader’s position. For example, BitMEX allows traders to hold Bitcoin as initial margin. If the Bitcoin rate falls, the amount of funds held as collateral also decreases, which leads to an even faster liquidation of the trader’s position. Because of such risks, some exchanges have set limits on the level of traders, and in a number of countries, regulators have completely banned crypto exchanges from offering leveraged products to retail investors in order to protect newcomers from liquidations and loss of capital. You can determine what percentage of an asset price change against a position will lead to its liquidation using the formula: 100 / leverage size. For example, with 5x leverage, the position will be liquidated if the price of the asset against the position moves by 20% (100/5 = 20).

One option to reduce the likelihood of liquidation when using leverage is known as a “stop loss”. This is a preliminary order that a trader places on an exchange, instructing it to sell an asset when it reaches a certain price point. When setting a stop loss, several parameters are set:
– Stop price: The price at which the stop loss order will be executed.
– Sale Price: The price at which a trader plans to sell a particular asset.
– Size: How much of the asset the trader plans to sell.
If the market price reaches the stop price, the stop order is automatically executed and sells the asset at the specified price and volume. If a trader feels that the market may move against him quickly, he may set the sell price lower than the stop price so that there is a greater chance that the order will be filled (bought by another trader). The main purpose of a stop loss is to limit potential losses.

While using higher leverage is generally considered riskier, position size also matters, as shown in the second scenario. Risk management is extremely important, so it makes sense for traders to have a plan in place in case the market does not move as expected. For example, the Bitcoin (BTC) rate continued to adjust on the night of December 13, immediately dropping to $40,696 on the Binance exchange in pairs with the stablecoin Tether USD (USDT). At 10:05 Hong Kong time, the first cryptocurrency is trading at $41,174. Before the correction began on December 11, the price of BTC was at $44 thousand. Other coins from the top 10 by capitalization generally follow the market leader. The second largest cryptocurrency Ethereum (ETH) is trading at $2,159, having fallen by 2.7% over the past day. The price of BNB fell to $246 after a short-term rise, Solana (SOL), Cardano (ADA) and Dogecoin (DOGE) lost 3% to 5% in price over the past 24 hours. The rate of the Avalanche (AVAX) token, which recently entered the top ten in terms of capitalization, after a long period of growth, has noticeably decreased: the coin fell by 16% in one day. Of the less capitalized coins, the memcoin Bonk (BONK) lost the most value. After prolonged growth and reaching historical highs, the coin rate fell by 25%. Sales began after the listing of the token was announced by the Coinbase exchange. The fall in prices for cryptocurrencies provoked a massive liquidation of margin positions on crypto exchanges. According to Coinglass, in one day the total amount of forcedly closed positions of more than 77 thousand traders exceeded $160 million, and the majority of traders who were liquidated held long positions, that is, they expected the continued growth of Bitcoin and other cryptocurrencies.

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