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EducationalNovember 16, 2019

Got Rekt? Liquidations in Crypto Derivatives Explained

Jitender Tokas
Chief Business Officer
November 16, 2019

At some point in your cryptocurrency futures trading, you are bound to experience a liquidation event where your position is forcibly closed. In popular lingo, this is also known as ‘getting rekt’. For novice traders and those who are unfamiliar with cryptocurrency derivatives trading, experiencing their first liquidation event can be confusing and frustrating. The combination of high volatility in crypto prices and high leverage offered by exchanges means that an open position can be liquidated suddenly, without any pre-warning as the underlying crypto-asset moves adversely.

In this article we explain why liquidations are an integral part of leveraged trading. We also touch upon the various strategies crypto futures exchanges use to handle liquidations and why the intelligent liquidation mechanism that we employ at Delta Exchange is the best in the industry.

Liquidations: a feature or a bug?

You might have wondered about this question, especially given the propensity of crypto exchanges to make mistakes. Would liquidations happen if everything works as it should? Do liquidations ever happen at exchanges like NYSE and NASDAQ? The answer to both is yes.

Liquidations are a by-product of leverage. By taking advantage of leverage, a trader is able to open a position that’s several times bigger than his capital (aka margin). In fact, leverage = position size/ margin.

The key to understanding liquidations is the fact that any losses from this trade will have to be funded from the margin. In situations where price moves adversely to a trader’s open position, the margin provided by the trader gets eroded by unrealized losses. When unrealized losses become equal to the margin, the trader’s position has to be liquidated.

How do liquidations work at a typical crypto derivatives exchange

To be able understand the mechanics of liquidations, we need to learn a few terms:

  • Initial margin: This is the capital provided by the trader at the time of opening a position
  • Bankruptcy price: This is the price at which unrealized losses will be equal to the Initial Margin
  • Maintenance margin: This is the minimum amount of capital, inclusive of unrealized profit/ loss, that’s needed to keep a position open. When (Initial Margin – Unrealised losses) < Maintenance Margin, a position goes into liquidation.
  • Liquidation Price: The price at which a position goes into liquidation. This is the price at which Maintenance Margin breach happens.

Once a position goes into liquidation, it is taken over by the liquidation engine. The liquidation engine closes the position by placing an appropriate order in the order book. It is worth noting that exchanges do not initiate liquidation at the Bankruptcy Price. Instead, liquidation starts when there’s still some margin left in the position. This leftover margin serves as a safety buffer to help ensure that the position is closed before Bankruptcy Price is breached.

How is liquidation mechanism at Delta Exchange better

  • Partial Liquidations: Unlike most exchanges, we do not liquidate a position completely in a single shot. Instead, we compute the minimum size that needs to be liquidated to ensure that the remaining position has sufficient margin. Our approach is more nuanced than even leading exchanges like BitMex that do partial liquidation in fixed steps. Our more flexible partial liquidation mechanism is less disruptive and trader friendly.
  • Intelligent Liquidation Strategy: Our Liquidation Engine doesn’t deploy a blunt approach to closing positions assigned to it. Instead, the Liquidation Engine attempts to minimize market impact of liquidations by being patient and placing close orders intelligently.

The complete details of how liquidations work on Delta Exchange are available here.

How can you avoid getting liquidated

Use lower leverage in your trades

Recall that leverage = position size/ margin. Higher leverage means your capital, i.e. margin is much smaller relative to your position size. A natural consequence of keeping lower margin is higher probability of getting liquidated. If you open a long position in the BTCUSD perpetual contract at 100x leverage, a mere 0.5% drop in BTC price would trigger the liquidation of your position. However, if you had used 10x leverage, it would take a 5% move down in BTC price before your position goes into liquidation.

Add margin to your position

In traditional financial markets, when the maintenance margin of a position is breached, a “margin call” is sent to the trader. This is an opportunity for the trader to add margin to his position to avoid getting liquidated. In the context of crypto derivatives trading, margin call doesn’t work due to a multitude of reasons: (a) crypto trading happens 24/7/365, (b) crypto markets have very high volatility and (c) crypto exchanges offer quite high leverage. The combination of the factors mentioned above means that price can go from Liquidation Price to Bankruptcy Price very quickly, leaving little time for the exchange and trader to react.

Given the unique nature of crypto markets, we at Delta Exchange have implemented a novel solution called auto margin top-up, which allows traders to use their funds to automatically add margin to open positions to avoid a liquidation event. Traders can selectively enable auto margin top-up on those of their positions that they don’t want to go into liquidation.

Use stoploss orders

Risk management is just as crucial part of being a successful trader as making right calls about market direction. Disciplined traders always set stoploss and take-profit levels for their open positions. By establishing stoploss levels (by placing stop orders or trailing stop orders) you can close open positions at a predefined levels of unrealized loss. It is obvious that if your stoploss order will trigger before the Liquidation Price of a position then your position will be closed before it goes in liquidation.

At Delta Exchange, in addition to stop orders, we have bracket orders that enable traders to place OCO (one-cancels-the-other) take-profit and stoploss orders for open orders and positions. We highly recommend using bracket orders to better manage their open risk.

Side-effects of liquidations

If the exchange is unable to close the position of a trader before the Bankruptcy Price is breached, the trader realizes a loss that exceeds his capital. The key question here is, who bears this excess loss? Exchanges deploy various methods to deal with it:

  • Insurance fund: In this approach, an insurance fund is maintained by an exchange to absorb excess losses from liquidations.
  • Socialisation of losses: In this approach, excess losses from liquidations are distributed among profitable traders.
  • Auto-deleveraging: In this approach, when the Liquidation Engine is unable to close a position in liquidation before its Bankruptcy Price is breached, the position is closed by matching it against profitable positions on the opposite side. ADL trade is effected at the Bankruptcy Price, thus ensuring that the position is liquidation has no excess loss. At Delta Exchange, we use ADL. Complete details of our ADL mechanism are available here.

Important things to remember about liquidations

Properly preparing your trades with liquidation in mind will help you limit unnecessary losses and minimize the chances of your positions being forcefully closed. You should also be always cognizant of the fact that the likelihood of your position being liquidated is directly proportional to your leverage. If you are trading with more modest sums, it may be prudent to use a lower leverage ratio, or trade with just a portion of your funds, so that you don’t lose a significant amount in a liquidation event.

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