How Liquidations Work on Exchanges and Why They Become a Reality for Traders

Cryptocurrency markets never sleep. Unlike traditional financial markets, asset trading occurs 24/7. This feature creates unique opportunities but also poses significant risks. One of the most serious is liquidations on exchanges, which can wipe out a trader’s position in minutes. If you plan to use leverage, it’s essential to understand how this process works to avoid becoming its victim.

Mechanics of Liquidation: What Really Happens to Trader Positions

Liquidation on an exchange is the automatic closing of a participant’s trading position. This can only happen in margin trading using borrowed funds. When the market moves against a trader’s position, the collateral (their own funds) begins to decrease. The exchange requires compliance with certain margin ratios. If the balance falls below the set level, a margin call is triggered—an alert to add more funds to the account.

At this point, the trader has a critical window of time to act. They can deposit additional funds and save the position. However, if they do not, the exchange acts automatically. The system forcibly closes the position by selling assets at the market price. Due to high volatility, this price can be significantly lower than the entry level. Additionally, exchanges charge extra fees for liquidations, further increasing the trader’s loss.

The speed of this process is astonishing. On volatile markets, everything can happen in seconds. A trader may not even have time to realize what’s happening. That’s why risk management becomes a crucial tool.

Why Participants Use Leverage and What Risks It Carries

Leverage acts as an economic amplifier. Instead of investing $1,000 and earning profit on $1,000, a trader can put in $1,000 of their own funds and access $10,000 with 10x leverage. This means that a 1% price movement results in a 10% profit. Such potential magnetically attracts participants dreaming of higher income.

However, the mechanism works both ways. A 1% adverse price movement increases losses by 10 times. The exchange requires collateral to hedge against unfavorable moves. But during sharp price jumps, this safety cushion can vanish in milliseconds.

Cryptocurrency asset volatility intensifies this danger. Bitcoin can drop 10% in an hour, creating conditions for mass liquidations on exchanges. When many positions close simultaneously, it triggers a wave of selling that pushes the price down even further. This is called cascading liquidation, and it can destroy portfolios even of cautious traders.

Liquidation Levels and Factors Determining Position Closure on Exchanges

The liquidation level is the price at which a position will be automatically closed. It’s not a fixed value but a dynamic parameter dependent on multiple variables. The first and most important is the size of leverage. With 10x leverage, the liquidation level is much closer to the current price than with 2x.

The second variable is the maintenance margin ratio. Different exchanges set different requirements—some may require 5%, others 10%. This determines at what decline in capital the automatic closure occurs.

The third factor is the remaining funds in the account. The more borrowed funds relative to the trader’s own capital, the higher the risk. The system automatically monitors this balance and calculates the liquidation level in real time.

Additionally, trading fees and borrowing rates influence the process. All these parameters combine to define the point at which liquidations on exchanges become inevitable.

Full and Partial Liquidation on Crypto Exchanges: What Are the Differences

There are two main strategies for closing problematic positions. Partial liquidation is used when the system tries to minimize damage. Only part of the position is closed—just enough to bring the margin ratio back to normal. Often, this is a voluntary decision by the trader who sees danger and prefers to close part of the position themselves, preserving the rest.

Full liquidation is the last resort. All assets in the position are sold. The entire value goes toward covering losses. Usually, this is an involuntary process initiated by the exchange when the trader ignores the margin call or lacks funds to respond.

In extreme cases, liquidations on exchanges can lead to negative account balances. The participant loses not only their deposit but also owes funds to the exchange. To protect traders, most crypto exchanges use insurance funds. These cover such losses using collective reserves accumulated from fees. However, the mechanism isn’t always perfect, and in critical situations, protection may be insufficient.

Effective Ways to Protect Against Forced Liquidation on Exchanges

Professional traders employ two proven methods that significantly reduce the likelihood of catastrophic liquidations.

First—determine your personal risk percentage. It’s essential to set how much of your trading balance you’re willing to risk on a single position. The industry consensus: 1-3% of total capital per trade. This means that even with 100 consecutive losses (an unlikely scenario), your account won’t be completely wiped out. On volatile crypto markets, this safety cushion is vital.

Second—always use stop-loss orders. This automatic exit mechanism triggers at a specified loss level. For example, setting a stop at 2% below entry price. If the market reverses, the position closes automatically, and losses are controlled. It requires no constant monitoring and works even when you’re asleep.

Third—choose an appropriate leverage size. Beginners are advised to start with 2x or 3x maximum. This provides enough buffer for mistakes. As experience grows, leverage can be increased gradually and cautiously.

Fourth—constantly monitor the liquidation level. Before opening a position, explicitly check at what level automatic closure will occur. If this level is too close to the current price, reduce leverage.

All these tools work together to create a multi-layered protection system. None guarantees safety, but their combination greatly reduces the risk of liquidation.

The Overall Picture: Liquidations on Exchanges as a Systemic Risk

Liquidations on exchanges are an inherent part of the margin trading ecosystem. They serve as a mechanism for exchanges to protect themselves from losses but also pose dangers to unprepared participants. The process operates automatically and without mercy. Today, liquidations happen daily, closing positions of traders who underestimated the risk.

However, it’s not a verdict. Understanding how liquidation works, applying proper risk management tools, and maintaining discipline in trading can help avoid this trap. The key is not in avoiding risk (which is inevitable) but in managing it. Cryptocurrency markets will remain volatile, but a prepared trader can thrive amid this volatility.