Liquidations
What is a liquidation? π±
Liquidation is an important concept in the trading of perpetual futures. It occurs when a trader's position is forcibly closed by the exchange because their margin balance falls below the required maintenance level.
This often happens due to adverse market movements combined with high leverage. Liquidation serves as a protective mechanism to prevent traders from falling into negative equity and to safeguard the exchange from financial risk.
Liquidation Process π
When a position's margin falls below the maintenance margin level, the exchange initiates a liquidation to protect itself and the trader from negative account balances. Typically, a trader will receive a margin call before liquidation occurs, giving them a chance to add more funds π¦§
Example of Liquidation with Alice π¦§
Scenario
Alice decides to "long" on Bitcoin because she believes its price will rise. To amplify her potential gains, she uses 10x leverage to open a position worth $10,000. This means Alice only needs to deposit $1,000 as margin, which is her initial collateral to control the larger position.
Leverage: Allows Alice to control a bigger position with a smaller initial investment. Here, 10x leverage means that for every dollar Alice deposits, she controls ten dollars in the market.
Margin: The $1,000 Alice deposits is her marginβthe amount of money she puts up to open and maintain her position.
Adverse Market Movement
Unfortunately, Bitcoin's price starts to fall from $20,000 to $18,000. Since Alice used 10x leverage, her losses are amplified. A 10% drop in Bitcoin's price translates into a 100% loss of her margin because:
Loss Calculation: With 10x leverage, every 1% price movement causes a 10% change in Aliceβs position value. When Bitcoin drops 10%, the value of Aliceβs position falls by 100%.
As a result, Alice's initial margin of $1,000 is completely wiped out.
Liquidation Triggered
As Bitcoin's price falls further, Alice's margin balance drops below the maintenance marginβthe minimum amount required to keep her position open. The exchange then liquidates Alice's position to prevent her losses from exceeding her initial investment.
Liquidation: The process where the exchange automatically closes Alice's position to ensure she doesn't lose more money than she deposited.
Result: Alice's position is forcibly closed, and she loses her initial margin of $1,000. This protects both Alice and the exchange from any additional losses.
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