Forced liquidation refers to an involuntary conversion of assets into cash or cash equivalents (such as stablecoins). It is a mechanism that creates market orders to exit leveraged positions. The term liquidation simply means selling assets for cash. Forced liquidation means that this selling happens automatically, when certain conditions are met.
In the context of cryptocurrencies, forced liquidation happens when the investor or trader is unable to fulfill the margin requirements for a leveraged position. The concept of liquidation applies to both futures and margin trading.
When you’re trading with leverage, the liquidation price is something you’ll need to keep a close eye on. The higher the leverage you use, the closer the liquidation price is to your entry. How so? Let’s look at an example.
You start with $50. You enter a leveraged long position in the BTC/USDT market with 10x leverage, meaning your position size will be $500. So, this $500 consists of your $50 plus $450 that you borrow. What happens if the price of Bitcoin goes down 10%? The position is now worth $450. If the position incurred further losses, those would apply to the borrowed funds. The lender of those funds won’t risk a loss on your behalf, so they liquidate your position to protect their capital. This means that the position is closed, and you’ve lost your initial capital of $50.
Forced liquidation typically incurs an additional liquidation fee. This varies with each platform but exists to incentivize traders to manually close their positions before they’d have to be automatically liquidated. So make sure you understand all the risks before entering a leveraged position.
Many trading platforms will allow you to calculate your liquidation price before entering a position. Binance Futures has a handy calculator that lets you calculate your PnL (Profit and Loss), target price, and liquidation price in advance.
In more traditional settings, liquidation is also used in the context of bankruptcy procedures, where an entity is forced to convert their assets into “liquid” forms (cash).