Liquidation on a crypto exchange, what is it?
By Yuriy Bishko Updated December 21, 2022
- What is liquidation in crypto?
- Why does liquidation happen?
- How does crypto liquidation work?
- How does liquidation help to identify the market bottom?
What is liquidation in crypto?
Liquidation is the process by which an exchange forcibly reclaims a cryptocurrency that a trader has borrowed for trading. This happens if a trader uses a loan from an exchange or it is also called leverage.
Now let’s make it clearer and move on to the example.
1. Imagine that a trader has $5,000 and at the current price of Bitcoin $50,000 it is 0.1 Bitcoin. But he wants to open a trade on 1 Bitcoin to earn more on rising prices. What does he do for this? He borrows $50,000 from the exchange and buys 1 Bitcoin with that money.
Now for a more detailed example of a successful trade.
2. A successful (profitable) trade. The price of Bitcoin has risen by 100% to $100,000. Thus, the trader already has 1 Bitcoin worth not $50,000, but $100,000. If he hadn’t taken a loan on the exchange, in order to earn $50,000 from the $5,000 balance, he would have to wait until Bitcoin grows by 1000%, i.e. 10 times to $500,000!
But what happens if the price starts to fall? What does an exchange do if a trader's loss exceeds the amount of money he has?
3. Liquidation. The same example, the same trade. The trader borrows $50,000 from the stock exchange and buys 1 Bitcoin for it, but the price begins to fall instead of rising. When the price falls by more than 10%, the value of Bitcoin is already $45,000. The exchange in this case thinks how the trader will return her money.
The trader's balance is $5,000, but the value of Bitcoin is already $45,000, and if the price falls below, the total balance will be less than the $50,000 that the trader owes. In order not to lose its money exchange:
- automatically closes the trade and sells 1 Bitcoin for $45,000.
- takes away $5,000 from the trader and covers the loss from the fall of Bitcoin.
- the exchange has returned its $50,000.
- the trader no longer owes anything, but he has lost money.
This is liquidation.
Why does liquidation happen?
As described earlier, liquidation occurs only if the price doesn't go in the direction of the trade and only in margin trading (using a loan). Margin trading is a type of trading in which a trader takes a loan from an exchange to open a trade. Due to this loan, the amount of money of a trader increases, which allows him to earn more.
Mostly beginners face liquidation, because they do not know the basics of trading:
- stop-loss setting technique;
- wrong amount of money for the trade (size of the position);
- weak analysis of the market or its absence at all.
Experienced traders also face liquidation, if they have paid little attention to rest and have overtraded. This is the condition of a trader who has opened a lot of emotional trades and violated the rules of trading.
How to determine the liquidation price?
The largest exchanges Binance and ByBit, which I use at the time of opening the transaction, show the liquidation price. When opening a short, a trade on the fall of the market, the liquidation price is higher than the entrance price. To take advantage of leverage, be sure to use these tips on the exchange.
How to use liquidation to buy crypto at a discount?
Liquidation is not only the price when the exchange closes the trade, but also an indicator that helps experienced traders to identify the best opportunities to open a trade.
With the cryptocurrency rising by 500-1000%, many traders, especially beginners, start to think they have some trading skills, rather than a growing crypto market helping them make money. They are starting to take more and more loans on the stock exchange. A $1,000 trader borrows 10 times (10x) more than his trading account and starts making big money until the market starts to fall.
This is where the most massive liquidations happen, when recent millionaires are left with modest deposits or no deposits at all. Fear is starting to prevail in the market, most are afraid to buy cryptocurrency. The Fear and Greed Indicator shows "Extreme Fear" during falls and large liquidations.
You may have heard Warren Buffett's famous quote: "I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.” This is exactly the moment.
In this picture you can see how to detect liquidations on the volume indicator. What is a volume indicator? This is an indicator that shows the number of buy and sell transactions. The higher the histogram, the more transactions and vice versa, the lower the histogram, the fewer transactions. The indicator itself is shown at the bottom of the picture as a histogram.
How it works:
- Inexperienced traders buy Bitcoins in white zones 1, 2, 3, 4 with the help of loans, i.e. with leverage.
- After a sharp drop in price by 50% (a white dotted line), the exchange forcibly closes almost all loan trades in order not to lose their own funds.
- Volumes on the histogram begin to grow with the number of trades, indicating the anomalous amount of cryptocurrency sold.
- The price, as we see from the example, after the mass liquidations does not continue to fall, but begins long-term growth.
From this example, we have learned that the liquidations we identified on the volume indicator help to determine the lowest Bitcoin price with the greatest growth potential. Traders also say it helps to determine the "bottom" of the market.
Can we use liquidation to make more successful trades? Yes, of course you can. With the volume and liquidation indicator, you can determine the best trades. In the picture below, we can see large volumes (*means large liquidations of traders) and a push under the trend line, after which you can open a trade for +16% profit.
Also, you can determine the best price for the purchase at the expense of liquidation data on information sites or in our telegram channel in which the most up-to-date information is published.
You can be liquidated, and you can use liquidation for extra earnings and here the choice is only for the trader. Learn, read articles and practical recommendations with updates on the site!