What is contract liquidation?

What is contract liquidation

Source:https://www.coinglass.com/zh/pro/futures/LiquidationMap

Liquidation, also known as forced closing, is a mandatory operation taken by an exchange to prevent traders from being unable to repay their losses. It usually occurs in high-risk investment scenarios such as perpetual contract trading, leverage trading, and margin trading. The core triggering condition for liquidation is that the trader's margin is insufficient to support the minimum margin level required for opening a position. When the trader's losses are too great, resulting in insufficient margin, the exchange will forcibly close the trader's position according to predetermined rules.

For example, suppose you use 10x leverage in a trade and open a long position on BTC. If the price of BTC drops by 10% and you do not add additional margin, your position may face the risk of liquidation. In this case, the exchange will automatically sell your position to avoid further losses.

Classification of Liquidation

Liquidation can be divided into partial liquidation and complete liquidation:

• Partial Liquidation: When the initial margin of an account has not been fully used, the exchange will only liquidate a portion of the position. In this case, if the market price reverses, traders may be able to recover losses and maintain their positions. However, if the price continues to fall, the remaining position may face greater risks.
• Liquidation: When a trader's losses reach a certain level and can no longer maintain the minimum margin requirement, the exchange will directly liquidate all positions. This can help traders avoid 'liquidation' (i.e., account balance becomes negative), but it also means that traders miss the opportunity for a rebound in the market.

The meaning of settlement

Although liquidation usually means losses for traders, it has its positive side. It can effectively prevent traders from suffering more serious losses due to excessive leverage, especially in extreme market fluctuations. For example, in a market crash, if liquidation is not carried out, traders' losses may be infinitely magnified, leading to account 'liquidation' and additional debt or over-leverage.

The clearing mechanism protects the overall stability of the exchange and the market, avoids the risk of traders' losses expanding, and prevents the chain reaction of market collapse.

Calculation of liquidation price

The calculation of the liquidation price is not a simple process, it requires comprehensive consideration of factors such as leverage, entry price, position size, and maintenance margin ratio. The following is the general formula for calculating the liquidation price.

Long position liquidation price:

Liquidation Price for Short Position:

Among them,

• Entry Price: The price at which a trader opens a position.
• Initial Margin: The collateral ratio required when opening a position, usually determined by the leverage ratio.
• Maintenance Margin: The minimum margin ratio required to maintain a position.
• Position Size: The actual size of the contract, usually expressed in contract units.

In actual calculation, the exchange may incorporate additional factors such as funding rates, fees, and other margin requirements, so it is important to understand the specific rules of the exchange.

Clearing Mechanism and Fees

Taking long positions as an example, assuming you use $100 as initial margin and open a position with 10x leverage, borrowing $900, the total position will be $1000. If the market price rises by 10%, you will gain a profit of $100. If the price falls by 10%, your total position will become $900, and the system will determine whether to liquidate.

When the loss reaches a certain level (e.g. 10%), if additional margin is not added in time, the exchange will force liquidate the position. Forced liquidation not only closes the position, but may also incur additional fees. These fees are designed to incentivize traders to voluntarily close their positions before losses occur.

Here is the liquidation process:

1. Trigger condition: When the margin ratio of an account (i.e., the ratio of margin to position value) drops to a certain level, the system will trigger a forced liquidation. For example, when the margin ratio is below 100%, the system will start liquidation.
2. Cancellation: The system will cancel all outstanding orders in the account (including strategy orders) and begin the liquidation process.
3. Step-wise Position Liquidation: The system will gradually reduce the risk limit of the position and begin forced liquidation when it reaches the liquidation point. During this process, the system will check whether the margin ratio has rebounded. If it rebounds, the liquidation operation will be stopped.
4. Liquidation price and bankruptcy price: When the market price touches the liquidation price, the system will sell the position at the market price. If the actual transaction price is better than the bankruptcy price, the exchange will use the insurance fund to compensate for the difference; if the price is lower than the bankruptcy price, the risk reserve pool needs to be used.

How to deal with liquidation risk?

To avoid forced liquidation, traders can take the following measures:

• Maintain sufficient margin: maintaining sufficient margin is the primary measure to prevent liquidation. If there are unfavorable fluctuations in the market, adding margin can avoid forced liquidation.
• Use leverage reasonably: Although high leverage can amplify profits, it also increases risks. Using leverage reasonably and adjusting positions according to market fluctuations is an effective way to reduce liquidation risk.
• Using Stop Orders: Stop orders can help traders automatically exit positions and reduce losses when market prices fluctuate.

Summary

Liquidation is an important risk control mechanism that can protect the stability of exchanges and markets, preventing traders' losses from expanding unlimitedly. In a high-leverage trading environment, liquidation provides traders with the function of "stop-loss", avoiding greater risks caused by excessive leverage. However, liquidation also means that traders may miss the opportunity of market rebound. Therefore, when conducting contract trading, it is necessary to manage risks carefully, set positions and margins reasonably to avoid being forced to liquidate.

By understanding the clearing mechanism and operating reasonably, traders can better avoid the risk of liquidation, and increase the security and profit opportunities of trading.