Volatility remains one of the key aspects of the crypto market, particularly in derivatives trading, where leveraging is used to magnify positions. The more people trade using borrowed funds, the more often position liquidations occur in times of market volatility.
Cryptocurrency liquidations happen anytime the increasing price on the market causes traders not to have enough margin for their bearish positions, which means those positions get closed automatically due to buy orders executed by the exchange.
What Is a Crypto Liquidation?
Crypto liquidation is an automatic closure of a leverage trading account when the trader’s collateral cannot offset the accumulated losses. The main objective of exchanges through liquidation is to avoid losses being higher than the initial amount used as collateral.
Leverage enables traders to trade above their capital by borrowing more money from the exchange. In this case, the trader does not have to use the whole capital for the trade but rather uses a margin.
For instance, a trader who puts $200 with 10 times leverage will be controlling $2,000. If the market goes against the trader, causing losses that exceed his margin, the exchange closes the account.
Short Liquidations in Cryptocurrency
A short trade involves profiting from falling prices in the cryptocurrency. This trade is opened by the trader using derivatives such as futures and perpetual contracts, and not directly buying the cryptocurrency.
In crypto, a short liquidation occurs when the price goes up instead of down. Once the price touches the liquidation level of the trader, the trade is closed by forcing a buy trade at the specified level by the exchange. In this process, the posted margin of the trader is lost.
Leverage, in this case, plays a crucial role. The higher the leverage employed, the lower the liquidation level becomes.
How does leverage change liquidation risk?
- Around 10x leverage may lead to liquidation after an 8% to 10% adverse price move, depending on maintenance margin requirements.
- Around 5x leverage generally allows a larger movement of approximately 16% to 20% before liquidation.
- Most major exchanges display an estimated liquidation price before a trade is opened.
How Liquidation Cascades Can Develop
An individual short liquidation generally has little effect on the market because it creates only one buy order. The situation changes when many traders hold similar leveraged positions with liquidation prices concentrated in the same range.
As prices rise, the first group of short positions reaches its liquidation level. Exchanges then place forced buy orders to close those trades. As the buying pressure increases even more, prices are pushed even higher, and another wave of liquidations follows.
Such a sequence of events is referred to as a liquidation cascade.
Features of a liquidation cascade
- Forced buying increases market demand.
- Extra liquidations follow because prices keep going up.
- The process can unfold rapidly when market liquidity is limited.
Long Liquidations Work in Reverse
Long liquidations follow the same process but occur during falling markets.
A leveraged long position is intended to benefit from rising prices. Prices fall to the point where the trader’s liquidation level is reached, and his position is closed via an automatic sale.
A group of longs being liquidated could add to selling pressure, thereby contributing to rapid price falls, as could a group of shorts causing fast rises in the market.
Why Do Crypto Markets Have Regular Liquidations?
There are a few features of crypto derivatives markets that make it easier for there to be liquidation-led price movements.
| Features of the Market | Effect on Liquidation Risk |
| High leverage | Small price changes will lead to liquidations. |
| Continuous 24/7 trading | Low liquidity will intensify forced buying/selling. |
| High market volatility | Big percentage price changes take place regularly. |
| Concentrated positioning | Traders at similar leverage have liquidation levels near each other. |
Short Liquidation Monitoring in Crypto
There are various market indicators that help traders identify the zones with a concentration of leveraged trades.
CoinGlass is an exchange that collects live as well as historical data on liquidations from various crypto exchanges. It shows liquidation values in terms of assets, direction, and time frames.
The liquidation heatmap provides an estimation of the zones in which there is a concentration of liquidations at different price levels. Zones with high concentrations of estimated liquidation levels show up as higher intensity zones.
Other common indicators that are usually tracked include:
- Open interest is the measure of the number of outstanding derivatives contracts.
- Funding rates, which signal that either long or short positions are dominating the perpetual futures markets.
- Heatmaps of estimated liquidation prices.
- The above indicators are not used for predicting market directions, but rather provide some information about the positions of leveraged traders.
Conclusion
Short liquidations of cryptos are a natural phenomenon within leveraged derivative markets, which involves closing leveraged bearish positions once rising prices deplete the trader’s equity. While a single instance of a short liquidation is unlikely to affect the price of the underlying asset, a combination of short liquidations among many leveraged positions can lead to a liquidation cascade, which will contribute to price fluctuations.
FAQs
What is meant by short liquidations in crypto?
In short liquidations, the increase in the price of cryptocurrencies leads to an automatic closing of short leveraged positions because the balance of the trader cannot cover their losses.
What triggers short liquidation?
The short liquidation is triggered when the market price moves beyond the liquidation level of the trader due to the unexpected surge in price.
How is short liquidation different from long liquidation?
Short liquidations take place when there is an uptrend in the market, while long liquidations occur when there is a downtrend in the market.
