fbpx

Liquidation Orders: Explained

Trading perpetual futures contracts for Bitcoin or Ethereum is a special way in which you can engage crypto assets. It’s different than trading these assets on the spot market because

  1. You don’t actually ‘own’ the asset in the hope that it will increase in value. Rather, it’s more like ‘betting’ in the sense that you can either go ‘long’ or ‘short’, depending on whether you expect the price of the asset to go up or down, respectively. 
  2. You can trade with high leverage – this means that although you only put in $10 into a trade, with 100x leverage you can essentially enter the market with $1000.
  3. If price movements do not follow your expectation, you can be ‘liquidated’, meaning you can be automatically made to close your position and lose the entire amount you’ve put into the market. 

Recently, we’ve been receiving questions about what it means to be auto-liquidated, so we want to take this opportunity to help our users understand it better. 

We have made the article as easy as possible by using simple equations. All you need to do is follow the logic.

  • If you first want to learn more about futures trading in general, have a look at our Beginner’s Guide
  • Also, we will soon be rolling out new futures contracts with USDT as the settlement currency. You can learn more about this here

Liquidation? Let’s start with an easy example

Let’s say, the price of BTC is $10,000, and you enter the futures market, expecting the price to go up. In other words, you go ‘long’. 

You put in $500 USD, with no leverage. 

If the price of BTC drops from $10,000 to $9,000 (i.e. -10%), then your $500 would have also dropped to $450. At that point, if you’re afraid the price may drop further, you could decide to exit the market. Of course, the price could recover and it is still possible to make a profit. 

You will not be auto-liquidated, unless the price of BTC drops all the way down to $0 (i.e. 100%). 

What happens when you trade with leverage?

When you trade with leverage, you are essentially borrowing money from the market to gain more exposure. 

Let’s say, the price of BTC is $10,000. You expect the price to go up, but this time you put in $500 with 10x leverage. 

Now you are in the market with $500 x 10 = $5000 USD worth of contracts.

This is attractive because if the price of BTC goes up, your profits are magnified 10x as well. 

But the same applies to your losses. 

Now, if the price of BTC drops from $10,000 to $9,000, in other words, the price drops by 10%, you may be in trouble. 

Why? Because although you’ve only put $500 dollars into the trade, because you did so with 10x leverage, you are exposed to price movements with $5,000 worth of contracts.

A 10% drop for you, means your $5000 has now turned into 5000 x 0.9 = $4,500.

In other words, you’ve lost $500 – or, the actual amount you put into the trade. This means you must exit the market. 

The auto-liquidation order is there to protect you, because if the price were to drop further and you lose more than your initial margin, then you would suddenly find yourself in debt. To prevent this from happening, we’ve designed our futures products in such a way that you can never lose more than what you’ve put in. 

Remember: on the futures market you can go long and short. The above example, where you go long but the price goes down, works the exact same way, if you go short and the price goes up. 

How can you prevent liquidation? 

There are several ways you can prevent being liquidated. 

The easiest method is simply exiting the market on time. If you go short, for example, and you see the price keeps rising, you can exit the market, and although you will have made a loss, you won’t have lost everything. 

An alternative to this method is by putting a stop-loss order in place. We would advise, however, not to place the trigger price too close to the liquidation price, because in moments of high market volatility a stop-loss may not always be effective.

But there is another way. 

Let’s say, you’ve put $500 in, and you did so with 50x leverage. This means you’ve entered the market with $25,000 worth of contracts, and both your losses and profits will be amplified by 50. 

If the market goes up by 2%, this means you will have made 100% profit (i.e. 2 x 50 = 100%). If you exit the market at that point, your $25,000 will have turned to 25,500, which means once you close your position, your $500 is now $1,000.

But what if the price goes in the opposite direction? Well, if the price drops by 2%, while you were expecting it to go up, then you will be auto-liquidated. 

Luckily, you can adjust your leverage. 

For example, if you adjust your leverage from 50x to 25x, you will need to put more money into the trade. 

  • You went in with $500 x 50 = $25,000 
  • After adjusting your leverage, you’re in the market with $1000 x 25 = $25,000

You’re holding the same position, but you’ve put more of your own funds into the trade.

Why is this useful? 

Because now, instead of 2%, you will not be liquidated until the price drops by 4%. 

  • In the former position, you will be at a 100% loss if the price drops by 2%, because 2 x 50 = 100%. 
  • In the latter position, you will be at a 100% loss if the price drops by 4%, because 4 x 25 = 100%. 

Further protective measures 

There are two more important points about how we’ve designed our futures products.

The mark price

First, remember that the futures market trades very closely to the global spot price – or, the mark price. 

Auto-liquidation does not happen on the basis of the price in the local order book. Instead, at AAX, we use the mark price.  

The mark price is calculated by AAX as it tracks the real time spot price of the asset on multiple exchanges, including Bitstamp, Bittrex, Coinbase, Gemini, Poloniex, Itbit, and Kraken. As it is based on a weighted average, price movements can be expected to be less volatile and more reliable than a single local order book. 

The insurance fund

Another measure we’ve put in place is the Insurance Fund. 

Here is how it works: instead of auto-liquidating your order exactly at the point where you would have lost 100%, we auto-liquidate your position slightly before full bankruptcy. The remainder is stored in the Insurance Fund. 

The reason is that if for some reason AAX is not able to perfectly close your position on time, resulting in a loss on your end that exceeds your initial input, so let’s say, instead $500 you’ve lost $550, then the Insurance Fund is used to cover the extra loss. 

In this way, we can make sure that no one loses more than their initial margin. 

Let’s make it super simple

Leverage magnifies your profits as well as your losses. 

  • 100x leverage means your profits as well as your losses will be magnified by 100.
  • You can never lose more than 100%. 
  • So if you go long, you will be liquidated slightly before the price has dropped by 1%; if you go short, you will be liquidated slightly before the price has risen by 1%. 
  • 50x leverage means your profits as well as your losses will be magnified by 50.
  • You can never lose more than 100%. 
  • So if you go long, you will be liquidated slightly before the price has dropped by 2%; if you go short, you will be liquidated slightly before the price has risen by 2%. 
  • 20x leverage means your profits as well as your losses will be magnified by 20.
  • You can never lose more than 100%. 
  • So if you go long, you will be liquidated slightly before the price has dropped by 5%; if you go short, you will be liquidated slightly before the price has risen by 5%. 
  • 10x leverage means your profits as well as your losses will be magnified by 10.
  • You can never lose more than 100%. 
  • So if you go long, you will be liquidated slightly before the price has dropped by 10%; if you go short, you will be liquidated slightly before the price has risen by 10%. 
  • 2x leverage means your profits as well as your losses will be magnified by 2.
  • You can never lose more than 100%. 
  • So if you go long, you will be liquidated slightly before the price has dropped by 50%; if you go short, you will be liquidated slightly before the price has risen by 50%. 

Unless you are absolutely sure about the direction of the market, it is best not to trade with too much leverage.

It is also good to keep some funds in your wallet, so that if you have to adjust your leverage, you are able to put a bit more into the trade.

If you think the price will continue to move against your expectation, you may be better off switching positions. Instead of long, you could go short; instead of short, you could go long. 

Trade with AAX

AAX is the world’s first digital asset exchange to be powered by LSEG Technology. Offering OTC, spot, and futures, it provides a highly secure, deeply liquid and ultra-low latency trading environment; and a meeting point between crypto and global finance. 

Open an account with AAX, or download the app, and experience the next generation crypto exchange.

Choose a language