Leverage Trading Liquidation Explanation And How To Avoid It
You’ve probably heard the term liquidation when it comes to trading with leverage, but what does it really mean, and how can we avoid getting liquidated while trading the financial markets?
If you have been a victim of liquidation or if you just want to educate yourself to protect your account, keep reading. Getting liquidated happens in the same way but there is a difference between the risks in forex vs crypto vs stocks where crypto is actually the less risky market to trade.
High leverage increases the risk of liquidation and that goes for all markets and all traders. To learn more read our guide: What is high leverage trading? Use our guide on high leverage trading strategies to improve your risk management skills and squeeze the profits out of your market.
Liquidation in leverage trading is what happens when your leveraged position has lost too much capital and your margin can’t support the overall losses of your account. When you get liquidated, all your positions are closed out, and all your funds are lost.
This is probably the worst-case scenario for any investor and today we are going to break down exactly what liquidation is and how we can avoid it in the future. When it comes to trade management, controlling your risk of liquidation is a priority, even when you are planning your trade.
You will learn
What is liquidation in leverage trading?
Liquidation is a complete loss of all capital in your live trading account due to losses that could not be supported by your margin capital. When you run out of funds in your leveraged account you will get a margin call telling you that you are almost out of support for your open position. If you don’t close out the position or add more funds to your account after getting the margin call and the market keeps going against you, you will suffer losses that are bigger than your overall account size, and all your positions will get closed out and liquidated.
After a liquidation, your account balance is set to 0 which means that all your deposited funds have been lost. It’s sad but true, it happens very frequently among novice traders who take on too much risk while trading the financial markets. You can get liquidated when trading any asset class and as long as your position has a leverage ratio of at least 1:2 there is a chance to get liquidated.
Without leverage, you cannot get liquidated since there are no borrowed funds connected to your open position. A non-leveraged position can only go to near zero value but no matter how big the losses are it can never liquidate your open position.
Can you go negative with leverage trading? Yes, it is possible, but only if your broker doesn’t support negative balance protection. Liquidation can also happen in leveraged long-term investing when the investor chooses a ratio that is too high.
Leverage forex trading is also an arena where traders are constantly liquidated due to overleveraged positions with a low margin requirement.
Why does liquidation happen?
Liquidation happens when your current account balance can’t support your open losses in your trading account. The calculation for this is pretty straightforward and can be explained with a simple example. Let’s say that you have a trading account of $1000 and you open a position with all this money. Your $1000 position will go up and down with the market and it can even lose as much as 99% of its value but it can never be liquidated.
Now, if we add a leverage ratio of 1:2 to this mix and open a maximum position size with your $1000 account your new maximum position size will be $2000. Remember that you only deposited $1000 in your account so your margin capital will only be able to handle a loss of $1000. If the position loses as much as $1001 you will get liquidated. In this example, we don’t take into consideration of commissions for opening the position. But this is the general idea of what liquidation means.
How to avoid liquidation
There are a couple of ways to avoid liquidation completely and I will give you some general advice on how to stay safe without running the risk of losing your whole account. In 90% of liquidation cases, it’s a beginner mistake that caused the loss of all funds, and if you know the basics of risk management when trading with leverage you will stay safe. Below is a list of the best ways to avoid liquidation in leverage trading:
- Use a low leverage ratio – Your leverage ratio is what decides your risk factor. A higher leverage ratio will reduce your liquidation price and increase the risk of getting liquidated. With a high leverage ratio, you have less room to play with when the market is fluctuating. A great tip is to analyze the average volatility of your asset class and choose your leverage ratio according to that metric. This will keep you away from danger.
- Calculate your margin requirement – One of the most important aspects of trading any asset class with leverage is to be able to calculate your leverage and your margin requirement for each position. If you know how much margin you put into each position then it’s less likely that you will liquidate your account. Use our crypto leverage calculator if you want to calculate your margin requirements on your crypto exchange.
- Use a stop loss – It’s nearly impossible to get liquidated when using a stop-loss order. On some rare occasions, your stop-loss level will not get hit and you take a significant loss but this is highly unlikely. In 99.9999% of the cases, your stop loss will determine your risk level and it should always be used when entering the market.
- Trade only one market – If you are a beginner trader I would recommend only trading on the market at the time to avoid confusion between your positions. It’s easier than you think to lose control over one or more positions if you have an account full of open positions in several markets. Focus on one market and do it well!
- Always use isolated margin – This is a big one. To avoid liquidating your whole account in any single trade I would recommend always using an isolated margin. Isolated margin means that you isolate the margin capital you used for one position only. This margin can not be used for other open positions and it will also disable your account from using more margin if one position goes heads south. To summarize, with an isolated margin you will only lose the margin you put up for one particular position.
- Avoid markets that gap up or down – It’s much more likely to lose your money if you trade an underlying asset that is closed during the weekends and opens with a gap up or gaps down on Monday morning. This way you can’t control your risk at all and you can only pray that the market is nice to you. Don’t leave your trades open over the weekend.
Leverage trading liquidation examples
If you have ever been liquidated I can only assume that it was a horrible experience that followed after a couple of bad losses and one final big loss that wiped out your entire stake. In this section, we are going to look at two different examples that can cause a liquidation in your trading account. The first example is a panic sell-off with a large position and the second example is a short position that gets out of control.
This is a typical scenario where a beginner is day trading and the market keeps climbing higher during the day and the trader adds to the position in every dip. Once the market gets overheated a large profit-taking sell-off initiates a panic sell-off that triggers a wave of liquidated positions. This could easily be avoided with the use of a stop-loss order or using a lower leverage ratio.
This type of liquidation usually happens very fast and the trader doesn’t see it coming before it’s too late. This was a drop of about 15%-20% and if you were to use a leverage ratio of more than 1:5 you could not handle this situation without adding more margin capital or closing out your position with a large loss.
Here is another common scenario where a trader thinks he or she has got a short position under control when in reality things could not be further from the truth. This happens a lot when novice traders try to short sell a market that is just doing a pullback before resuming the ongoing uptrend.
The market breaks down, indicating a negative sentiment, and the second break is the entry point for our beginner trader. He or she opens the short position at the lows and follows the market for a few days until the underlying positive trends come back to life and push the short position into a liquidation.
These kinds of swing trades are very dangerous because things can start off good and it gives you a false sense of security. What you should do in this case is to always use a stop loss to prevent liquidation. Short-selling is very difficult and should only be attempted at very low leverage ratios.
How to determine your liquidation risk
To know your liquidation risk or liquidation price you can make a simple calculation to determine how much room your position has to move before getting liquidated. For example, if you use a 1:2 leverage ratio, you have a 50% liquidation price. If you were to use a 1:3 leverage ratio, your liquidation price would shrink to 33%, and so on. Below is a table showing you the most common leverage ratios and their liquidation risks/prices.
As you can see, the more leverage you add to a position, the closer your liquidation price gets, and the higher your risk becomes. Use this table to calculate your own risk of liquidation when using leverage.
What other traders ask
When you get liquidated all your positions are closed out in a maximum loss and all your funds are lost.
Yes, leverage negatively affects the liquidation price. The more leverage you add the closer your liquidation price gets. A leverage ratio of 1:100 will be riskier to trade.
No, it is not possible to get liquidated with 1:1 leverage.
Yes, when you increase your leverage you take on significantly more risk and you stand a much higher chance of getting liquidated.
This depends if the broker has a negative balance protection policy. Without negative balance protection, it is possible for you to owe your broker money when getting liquidated.
1. Always use a stop loss.
2. Calculate your margin capital for each position.
3. Use a low leverage ratio.
4. Focus on one market only.
5. Always use an isolated margin.
No, it will not. The margin call is a warning sign that you are close to getting liquidated.
Liquidation is the worst-case scenario for any trader using leverage and in this guide, I explain how a liquidation happens, how it works, and also how to avoid it. I recommend that you start slowly and increase your leverage only when you feel comfortable.
You need to protect your downside risk at all costs. However, should you fall victim to a total liquidation, start over by first analyzing your mistakes.