Trading futures contracts with leverage has become immensely popular as more and more people discover they can profit even from small price movements. Also contributing to futures trading’s popularity is smaller traders’ ability to take large positions, as they need to fund only the initial margin to open their orders. For example, if you use 100 to 1 (100x) leverage with 1,000 USD, you will be managing a position worth 100,000 USD.
Unfortunately, leverage also comes with significant risks. Most crypto users are not careful with leverage and experience liquidation at some point in their trading careers. Just as a trader can enjoy magnified profits with a correct prediction, they can also see greater losses if the market goes against their position.
This lesson will explain what liquidation is and how it happens in futures trading. You can also read the following lessons for more beginner futures trading knowledge:
What is liquidation?
Liquidation is one of the risk management mechanisms exchanges like Huobi Futures use to protect traders from significant losses. It is an automatic and forced closing of a trader’s position that prevents their accounts from falling into negative equity. Liquidation happens if a position lacks the funds required to keep a leveraged trade open.
With liquidation, the exchange closes the position, meaning the trader loses at least part of their invested assets. The liquidation loss depends on the initial margin of a trade and the severity of the price decline.
Liquidation can be partial or total:
1. Partial liquidation: The system lowers the corresponding tier of an adjustment factor to avoid liquidating all positions at once.
2. Total liquidation: The entire position is closed once no initial margin is left – the trader loses all invested assets.
Not only would traders lose all their money without the liquidation feature, they would also have to repay their negative account balance. So even though traders curse liquidation in their tweets, the mechanism actually spares them from even more significant losses.
How does liquidation happen?
Traders experience liquidation because their positions no longer meet margin requirements. The margin is the percentage of the total trade value an exchange requires for a deposit to open a position. If the value of a trader’s margin account drops below the margin, the exchange will start liquidating his positions.
Huobi Futures show the following critical metrics related to liquidation that a trader should keep their eye on:
1. Est. liquidation price: The price at which the margin ratio will fall to zero and liquidation will be triggered.
2. Margin ratio: When the margin ratio falls to zero, forced liquidation will be triggered. The lower the margin ratio, the higher the risk.
Before reaching the liquidation threshold, a trader will receive a ‘margin call’, i.e., a reminder to either add more funds to the margin (if they believe the price will bounce back), close their position to save some assets, or wait to see the position gets liquidated.