Forced Liquidation Definition
Forced liquidation is a term used in the cryptocurrency trading that refers to the process where an exchange automatically closes a trader’s open positions to cover losses, especially when the trader’s margin balance falls below the required maintenance margin.
Forced Liquidation Key Points
- Forced liquidation takes place when a trader’s losses exceed the initial margin requirement.
- The exchange closes the open positions in forced liquidation, stopping further loss.
- Forced liquidation is a feature of margin trading used to manage risk for both the trader and the exchange.
What is Forced Liquidation?
Forced liquidation is a risk management measure in trading that is initiated when a trader’s margin balance falls below a certain threshold. When a trader is trading on margin, they are essentially borrowing funds to trade larger positions. If their positions start performing poorly, causing their margin balance to go below the required maintenance margin, a forced liquidation process is triggered.
Why Does Forced Liquidation Matter?
Forced liquidation is crucial for several reasons. For traders, it limits the amount of potential losses that they can incur when market conditions do not favor their open positions. For the exchange, it allows them to ensure that they can recover the funds that the trader has borrowed.
Where is Forced Liquidation Applied?
Forced liquidation is mostly applied in margin trading. Margin trading is an investment strategy that involves using borrowed funds from a broker or exchange to trade financial assets. This includes cryptocurrency, stocks, forex, and commodities.
Who are Affected by Forced Liquidation?
Both the trader and the exchange or broker are affected by forced liquidation. For traders, it may result in significant losses, as their positions are closed irrespective of their future potential. The exchange or broker also faces the risk of not being able to recover the borrowed funds if the trader’s losses exceed their collateral.
How Does Forced Liquidation Work?
The workings of forced liquidation entail the automated closure of a trader’s open position once their margin balance drops below the required maintenance margin. This closure is carried out by the exchange’s risk management systems which track every trader’s margin balance and the performance of their open positions. When the system detects a trader’s margin balance falling below the maintenance margin, it automatically triggers the forced liquidation function to close their positions and stop further losses.
