Forced liquidation is a concept every trader must understand – find out what it is and how it works below.
What Is Forced Liquidation?
Forced liquidation in the crypto context refers to an involuntary conversion of assets into cash or its equivalents like stablecoins, which occurs when a trader’s collateral falls below a certain threshold determined by the exchange.
What You Need To Know About Forced Liquidation
The forced liquidation definition is tightly interconnected with two other terms:
- Margin call level – it is the point at which an exchange issues a prompt for a trader to close some of the positions or add extra collateral funds to meet the minimum margin requirements. If it’s not done, some of the positions may undergo forced liquidation.
- Margin liquidation level – the threshold after which an automated forced liquidation process will occur to bring the account back into compliance with the minimum margin requirements.
These levels are set by exchange platforms as a means of protecting their interests by ensuring that the traders’ debts are fully covered. The thresholds vary depending on the exchange, but usually, a trader will receive a margin call when the margin level drops to 80%, while the forced liquidation typically gets triggered at 40%.
Here’s an example of how forced liquidation works:
Imagine you start with $50 and enter a leveraged long position in the BTC/USDT market with 10x leverage, your position size will be $500. This sum is made up of your own $50 and the $450 that you borrow.
In case the price of Bitcoin drops by 10%, the value of your position will decrease to $450. If the price continues to fall, the losses will affect the borrowed funds. To protect their investment, the exchange will liquidate your position, resulting in you losing the initial capital.
Thus, forced liquidation often means significant losses for the trader, especially if the market is experiencing a sharp decline.
To avoid forced liquidation, you need to be aware of the margin call level for the assets you’re trading and monitor your collateral levels closely.
