During the past week, a crypto trader purportedly suffered a $1 million loss in USDT overnight while engaging in margin trading of the meme coin PEPE on Binance.
Identified under the pseudonym Crypto Nerd on X (formerly Twitter), the trader disclosed the losses on April 13. Crypto Nerd elaborated that they had initiated a 3x-leverage long position on PEPE, utilizing $1 million worth of Tether's stablecoin USDT.
The situation took a distressing turn considering the trader's financial circ*mstances; reportedly, he possess less than $1,000 in his bank account.
"Upon waking up, I discovered I had been liquidated overnight. I had a 3x long position on PEPE. I lost everything I had. With less than $1,000 in my bank account, I had $1 million invested on Binance. I've been involved in crypto since 2017. Today, I've lost everything," he lamented. This prompts a reflection on the concept of liquidity and its implications.
What is Liquidation?
In the cryptocurrency market context, liquidation occurs when an exchange forcibly closes a trader's leveraged position due to either partial or total loss of the trader's initial margin. This happens when the trader fails to meet the margin requirements for a leveraged position, lacking sufficient funds to sustain the trade.
Both margin and futures trading can experience liquidation events. Leveraged trading is inherently high-risk, with the potential for a complete loss of collateral (initial margin) if the market moves significantly against the leveraged position. Recognizing the risks involved, some jurisdictions like the United Kingdom have banned crypto exchanges from offering leveraged trading products to retail investors, aiming to safeguard novice traders from liquidation and the subsequent loss of their invested capital.
To gauge the vulnerability of a leveraged position to liquidation, traders can utilize a simple formula:
Liquidation % = 100 / Leverage
For example, employing 5x leverage means the position will be liquidated if the asset's price moves 20% against the trader's position (100/5 = 20). This calculation provides traders with insights into the level of market movement required to trigger liquidation, assisting in risk management strategies.
What are Types of Liquidation?
Crypto liquidation encompasses two primary types: partial liquidation and total liquidation. These variations primarily differ in the degree to which a trading position is closed.
Both types of liquidation serve distinct purposes and are implemented based on the trader's strategy, risk tolerance, and market conditions.
How to avoid liquidation
When employing leverage in trading, employing risk mitigation strategies is crucial, and one such strategy is the implementation of a "stop loss."
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A stop loss, also referred to as a "stop order" or "stop-market order," is an advanced instruction that an investor issues to a crypto exchange, directing the exchange to sell an asset once it reaches a specified price level.
Setting up a stop loss involves inputting several parameters:
When the market price reaches the stop price, the stop order is automatically executed, and the asset is sold at the specified price and quantity. To enhance the likelihood of the order being filled swiftly, traders may set the sell price slightly lower than the stop price, increasing the probability of the order being matched by another trader. This precaution is particularly useful when traders anticipate rapid adverse market movements.
Look at the two scenarios below:
Scenario 1:
Potential loss with a stop loss: Potential loss = Position size Stop loss distance = $1,000 3% = $30
This represents 0.3% of the trader's entire account size ($30 / $10,000).
Without a stop loss, the position would be liquidated if there's a 15% drop in the asset's price, risking the entire initial margin of $200.
Scenario 2:
Potential loss with a stop loss: Potential loss = Position size Stop loss distance = $15,000 2% = $300
This represents a 2% loss from the trader's entire account ($300 / $15,000).
The lesson remains the same: while higher leverage can amplify gains, it also increases potential losses, especially with larger position sizes. Managing risk effectively is paramount, with a suggested guideline of keeping losses per trade below 1.5% of the entire account size.
Setting A Stop Loss
Determining where to set a stop loss is a critical decision that depends on various factors, including your risk tolerance, trading strategy, market volatility, and the specific characteristics of the asset being traded. Here are some considerations to help you decide where to set your stop loss: