What is Liquidation?

What is Liquidation?

Liquidation is the forced closure of your trading position by the exchange when your margin balance falls below the maintenance margin requirement. When you are liquidated, you lose most or all of the margin allocated to that position. It is one of the most significant risks in leveraged trading.

When Does Liquidation Happen?

Liquidation occurs when the unrealized loss on your position consumes your margin down to the maintenance margin level. The exact liquidation price depends on three factors:

1. Your entry price: Where you opened the position.
2. Your leverage: Higher leverage means a closer liquidation price.
3. The maintenance margin rate: Set by the exchange.

Example with a long position:

You open a long position on ETH at $2,000 with 10x leverage using $100 margin (position size: $1,000).

• With a typical 0.5% maintenance margin rate, your maintenance margin is $5.
• Your position can absorb approximately $95 in losses before liquidation.
• A $95 loss on a $1,000 position equals a 9.5% price drop.
• Your liquidation price is approximately $1,810.

With 5x leverage and $100 margin, the same math gives you roughly an 18% buffer, meaning liquidation would occur around $1,640.

The Liquidation Process

When the mark price reaches your liquidation price, the exchange takes over:

1. The exchange closes your position at the current market price.
2. A liquidation fee is charged (typically 0.5%-1% of the position size).
3. Remaining margin after the fee, if any, is returned to your account.
4. If losses exceed your margin, the insurance fund covers the difference (on most exchanges).

Note that liquidation is calculated using the mark price, not the last traded price. This protects traders from manipulation-driven liquidations caused by momentary price spikes.

How to Prevent Liquidation

1. Use Lower Leverage

This is the simplest and most effective prevention method. Lower leverage gives your position more room to breathe.

2. Set Stop-Loss Orders

Place a stop-loss order above your liquidation price. This automatically closes your position at a predetermined loss level, preventing liquidation. A good rule of thumb is to set your stop-loss at least 2-3% above your liquidation price.

3. Monitor Your Margin Ratio

Keep an eye on your margin ratio. Most exchanges show this as a percentage. When it approaches 100%, you are close to liquidation.

4. Add More Margin

If your position is moving against you, you can add more margin to push your liquidation price further away. This buys time but also increases your potential total loss.

5. Reduce Position Size

You can partially close your position to reduce your exposure and improve your margin ratio.

6. Avoid Overexposure

Do not put all your capital into a single leveraged position. Keep reserves to either add margin or absorb losses from liquidation.

Liquidation and Grid Bots

Grid bots face a unique liquidation challenge because they accumulate positions as the price moves. In a long grid bot:

• As the price drops, the bot buys at each grid level.
• Each purchase adds to the total position size.
• The combined position increases the overall liquidation risk.

This is why grid bots should be configured with conservative leverage and sufficient capital to cover the maximum possible position size (all grid levels filled). The grid break feature acts as a safety mechanism, shutting down the bot when the price moves outside the grid range before liquidation can occur.

Summary

• Liquidation is the forced closure of your position when margin falls below the maintenance requirement, calculated using the mark price.
• Lower leverage is the most effective way to prevent liquidation, with 2x giving approximately 50% buffer versus 10x giving only 10%.
• Grid bots accumulate positions as price moves against them, making conservative leverage and grid break protection essential to avoid liquidation.

Next Step

Now that you understand the risks, let us learn about the mechanism that facilitates all trades: What is an Order Book?