Liquidation

A liquidation is the forced closing of a position or loan. It happens when there isn’t enough collateral left to cover the risk.

What is liquidation?

Liquidations are most common with futures and perpetuals. These are contracts that let you trade without buying the cryptocurrency itself. Traders often use leverage with these contracts, opening a larger position with a smaller amount of money.

That initial amount is called margin and serves as collateral. If the price moves too far in the wrong direction, the collateral loses value. If it falls below a minimum level, a crypto exchange can automatically close all or part of the position.

Liquidations can also happen with a DeFi loan. You lock up crypto as collateral to borrow tokens. If the collateral’s value falls too far relative to the debt, a liquidator can repay part of the debt and receive collateral.

An example of liquidation

Someone opens a leveraged long position. They expect the price to rise, but it falls sharply instead. As a result, the available margin keeps shrinking.

If the margin drops below the required level, the platform automatically closes the position. This prevents the loss from growing further, but the trader has still lost money.

Why are liquidations important in crypto?

Liquidations show that trading with leverage carries extra risk. The higher the leverage, the less room there usually is for a price move in the wrong direction. Fast price movements in the crypto market increase this risk.

News about a sharp rise or fall sometimes includes large liquidation totals. Many long liquidations can add selling pressure. Many short liquidations can add buying pressure. This can make an existing price move stronger.

A reported total doesn’t automatically mean that the same amount of crypto was bought or sold on the spot market. It mainly represents the forced closing of derivatives positions or the settlement of loans.