Crypto Futures, Leverage, and everything in between
Firstly, what is Futures Trading? In brief, it is a derivative financial instrument that allows an investor or trader to control a larger contract value that has an expiry date, by putting up a relatively smaller margin amount. Crypto Futures contracts are generally perpetual in nature, which means that they have no expiry date. But other than that, they retain all the same properties of a traditional futures contract, especially leverage.
Read more on: Traditional Futures vs Crypto Futures Contract
Leverage is what allows a trader or an investor to control a larger contract value derived from an underlying asset by putting up a smaller margin amount. It is essentially a situation where the exchange running the futures market doles out a loan against the margin money.
Thus, if a trader opts for a 10x leverage on a BTC/USDT futures contract, the trader only needs to pay $100 in margin money to control a stake worth $1000, after getting a loan of $900 from the exchange.
There are several risk-containing protocols in place, the primary one of which we are going to discuss in this article below.
So, what is Liquidation in Crypto Futures?
So the term liquidation, in general, means the conversion of any investment asset back into cash. While that is something you can look forward to, in the world of Futures trading, liquidation is something that you should try to avoid at all costs.
When one takes a leveraged position in the market, the exchange loans the remaining amount to trade with and also attempts to secure its own capital by putting a hard limit on the trade, if it goes into the loss-making territory. This is because leveraged positions in the futures markets are prone to volatility and price swings which can cause a trader’s working capital to go into negative balance in an instant. In those cases, where the losses are greater than the maintenance margin, the exchange facilitating the market executes a liquidation of the trade, which typically results in the trader losing all of one’s capital in the trade.
Liquidation can happen very quickly or relatively slower and can be farther away depending on the amount of leverage taken by the Futures trader in any particular trade. Thus, a trade with lower leverage won’t see liquidations happening soon as minor corrections will not trigger it. On the flip side, higher levels of leverage can result in liquidation levels being much closer and spikes in volatility can result in major losses.
So when does Liquidation occur in Crypto Futures trading?
To understand this, let us take an example. Let us say we have a Trader A who enters into a long position on a BTC/USDT Futures contract at $100, with a 10x leverage. Thus, the contract value would be $1000. Let us assume the price of the BTC/USDT contract when Trader A enters the position was $25,000.
Now imagine, if in this scenario, the trade moves in the bullish direction, which is favorable to Trader A, by 1%. Now BTC/USDT is trading at a value of $25,250. The trader is now seeing a 10% unrealized profit on his position, of $10. But very quickly, the market changes direction and falls 2% from that high, and is now trading at $24,750 – which is 1% down from the average buying price.
This 1% unrealized loss, would amount to $10, which is something that the trader is not perturbed by, and hence he keeps his position open in the hopes that the price of BTC might recover very soon. However, as luck would have it, the price did not recover as expected, and the value of BTC/USDT is now down 10% from the average buy price, at $22,500.
Now in this situation, the trader is effectively facing an unrealized loss of $100, since he had entered the trade with a 10x leverage This is where the trader would be prompted by a margin call to add more funds to keep the trade active within a certain amount of time, and if not fulfilled, the trade would be “liquidated” by the exchange.
This is how liquidation occurs in crypto futures trading. This may differ based on the amount of leverage taken, thus a 5x leverage would have allowed the trader to hold on till the $20,000 mark before he or she was liquidated. A 20x leverage in this same scenario would have resulted in the trade being liquidated when BTC/USDT hit $23,750.
Handy Tips to Prevent Liquidation in Crypto Futures trading
- Use stop-loss orders on active trades.
- Be mindful of the amount of leverage you are exposing yourself to.
- Avoid taking trades that seem too risky.
Strategies to Minimize Liquidation in Crypto Futures Trading
- Have a trading plan: Developing a solid trading plan that is backed by data and a trader’s conviction can be a very good strategy to put into place to avoid hitting liquidation on your crypto Futures trades. Having a proper trading plan reduces the probability of liquidation as there is a framework a trader would abide by and thus enable them to conduct trading in a disciplined manner with strict risk and money management rules. It also removes impulsive trading urges from the equation, further improving the quality of your trading.
- Have a risk & money management strategy in place: Having a strict risk management strategy in place would greatly help a trader take better trades in the market, by reducing the losses incurred on bad trades and improving the profits gained on the good trades. This way, a trader can ensure their skew of profits vs losses remains on the positive side of things.
- Secure trading positions: It is absolutely essential to secure your trading positions in the market using various tools that we have available for you on the CoinDCX App. Using stop-loss orders is one of the most effective ways to contain the risk taken in futures trades by ensuring that the amount of risk a trader is undertaking is well-defined and limited. This removes the risk of liquidation completely too.
- Avoid compounding bad trades and losses: While compounding is a very commonly used technique in trading to increase a trader’s profitability by attempting to ride a current trend in the market, it is dangerous. Compounding, also known as Dollar-cost averaging is a tactic used to improve the average entry price on the position and is commonly used by seasoned traders. However, there should be a strategy in place to do it, or else one may lose more money in a bad trade than they had initially planned for.
Read more: Managing Risk in Crypto Futures
So, as one may have deduced from the article above, liquidation is a very critical aspect of Futures trading and a concept that everyone in the futures market should be familiar with. Traders need to understand it and what it entails and also a method to avoid that situation in the live market when they are trading with actual money. While futures trading does have a higher profit potential thanks to the leverage one is enabled to take, it is a double-edged sword and thus, implementing a proper trading plan with risk and money management strategies in place becomes paramount.
Read more: Guide to CoinDCX Futures Trading app
Dive into the perpetual vs quarterly futures debate for informed trading decisions!