Liquidation and Liquidation Cascades
What is Liquidation
Liquidation is when the exchange forcibly closes a position before losses exceed the margin. It's a safety mechanism to prevent traders from being unable to repay leveraged funds.
If you open a $100,000 BTC long position with $10,000 margin at 10x leverage, a roughly 10% BTC decline creates $10,000 in losses, exhausting your margin. In practice, forced liquidation occurs slightly before this due to maintenance margin requirements.
Liquidation is the worst-case scenario for traders. You lose your entire margin (isolated) or your entire account balance (cross margin).
Liquidation Price Calculation
Basic Formula
Liquidation price is determined by leverage, entry price, and margin mode. The exact formula varies by exchange, but approximate calculations are:
Long Position Liquidation Price (Isolated Margin):
Liquidation Price = Entry Price x (1 - 1/Leverage + Maintenance Margin Rate)
Short Position Liquidation Price (Isolated Margin):
Liquidation Price = Entry Price x (1 + 1/Leverage - Maintenance Margin Rate)
Liquidation Distance by Leverage Example
Opening a long position with BTC at $100,000 (assuming 0.5% maintenance margin rate):
| Leverage | Approximate Liquidation Price | vs Entry |
|---|---|---|
| 2x | ~$50,500 | -49.5% |
| 5x | ~$80,500 | -19.5% |
| 10x | ~$90,500 | -9.5% |
| 20x | ~$95,500 | -4.5% |
| 50x | ~$98,500 | -1.5% |
| 100x | ~$99,500 | -0.5% |
At 100x leverage, a 0.5% price movement causes liquidation. Just a $500 drop in BTC means losing everything.
The Liquidation Process
Stage 1: Margin Call
When position margin ratio reaches warning levels, the exchange sends an alert. At this point, the trader can:
- Add more margin, or
- Close part of the position to reduce leverage, or
- Stop-loss and exit the position entirely
Stage 2: Forced Liquidation
When margin ratio falls below maintenance margin rate, the exchange's liquidation engine automatically closes the position.
- Long liquidation: Market sell order, creates downward price pressure
- Short liquidation: Market buy order, creates upward price pressure
Stage 3: Insurance Fund
If liquidation executes at a better price than bankruptcy price, the difference goes to the insurance fund. Conversely, if liquidation executes worse than bankruptcy price, the insurance fund covers the difference.
Stage 4: ADL (Auto-Deleveraging)
The last-resort safety mechanism when the insurance fund is insufficient. The opposing positions with highest profits are automatically partially liquidated. This affects even profitable traders, making it the most undesirable outcome.
Liquidation Cascade
The Mechanism
A liquidation cascade is when one liquidation triggers a chain reaction causing more liquidations. It's one of the main reasons for sudden price spikes or crashes in cryptocurrency markets.
Long Liquidation Cascade:
- Price drops, triggering some long position liquidations (forced sells)
- Large sell orders push price down further
- Triggers liquidations at the next price level
- More selling leads to bigger drops
- Chain reaction continues until accumulated long positions are exhausted
Short Liquidation Cascade (Short Squeeze):
The same mechanism works in reverse. Short liquidation leads to forced buying, pushing prices up, triggering more short liquidations, causing rapid price spikes.
Conditions for Cascades
Cascades become more likely when these conditions are present:
- High open interest: More accumulated positions means more fuel for chain liquidations
- One-sided positioning: Extremely skewed long/short ratio
- High leverage: Liquidation prices close to current price
- Low liquidity: Thin order books amplify price impact of liquidation orders
Historical Cascade Examples
| Date | Direction | Liquidation Volume | Price Movement |
|---|---|---|---|
| 2020.03.12 | Long cascade | ~$1B | BTC -40% (1 day) |
| 2021.05.19 | Long cascade | ~$8B | BTC -30% |
| 2021.09.07 | Long cascade | ~$3.5B | BTC -19% |
| 2024.08.05 | Long cascade | ~$1B | BTC -15% |
March 12, 2020 ("Black Thursday") was the most extreme example, with BTC crashing over 40% in a single day while billions of dollars in positions were liquidated.
Liquidation Heatmap
Concept
A liquidation heatmap is a chart visualizing how many liquidation orders are pending at specific price levels. Provided by Coinglass, Hyblock Capital, and others.
Dense areas on the heatmap indicate that reaching that price would trigger massive liquidations. These areas often act as "magnets" that attract price.
Why Liquidation Zones Act as Magnets
- Large liquidation orders create abundant liquidity at those price levels
- Large players (market makers) have incentives to push price toward liquidity-rich zones to favorably close their own positions
- "Stop hunting": Intentionally pushing price to liquidation zones
Using Heatmaps
- Upper liquidation cluster: Reaching that price triggers short liquidation cascade, potentially accelerating further gains
- Lower liquidation cluster: Reaching that price triggers long liquidation cascade, potentially accelerating further losses
- Clusters on both sides: Large move possible in either direction. Prepare for increased volatility
Analyzing Liquidation Data
Daily Liquidation Volume
Total market daily liquidation volume is an indicator of market leverage levels.
| Daily Liquidations | Meaning |
|---|---|
| Under $100M | Normal. Stable market |
| $100M-500M | Active. Volatile market |
| $500M-1B | High. Significant leverage unwinding underway |
| Over $1B | Extreme. Major cascade occurring |
Long vs Short Liquidation Ratio
The ratio of longs to shorts in daily liquidations shows which direction suffered more. Predominantly long liquidations indicate downward movement dominated, while predominantly short liquidations indicate strong upward movement.
How to Avoid Liquidation
1. Use Low Leverage
The most reliable method. Leverage of 5x or lower rarely gets liquidated by normal market movements.
2. Set Stop-Losses
Set stop-loss orders before your liquidation price. For example, with 10x leverage and liquidation at -9.5%, set a stop-loss at -5% to preserve half your margin.
3. Use Isolated Margin
Using isolated margin limits maximum loss to allocated margin. Prevents losing your entire account.
4. Position Size Management
Limit each position to 5-10% of account balance. Minimizes the impact of any single liquidation on total capital.
5. Recognize Liquidation Zones
Use liquidation heatmaps or OI analysis to identify potential liquidation zones and avoid opening positions near them.
6. Avoid High-Volatility Events
Before events like FOMC announcements, CPI releases, or Bitcoin ETF decisions, reducing leverage or closing positions is safer. Prices can move 10%+ instantaneously during these events.
Combining with Other Indicators
Liquidation + OI Drop
Massive liquidations cause sharp drops in OI. The magnitude of OI decline indirectly indicates liquidation scale.
Liquidation + Volume Spike
Liquidation cascades are accompanied by volume surges since liquidation orders execute as market orders. When volume is 5-10x normal alongside sharp price movement, a cascade is likely underway.
Post-Liquidation Bounce
After massive liquidations complete, excessive leverage has been cleared, creating a "clean" state. Markets often rebound quickly afterward - known as the "Post-Liquidation Bounce."
Summary
Liquidation is the greatest risk in leveraged trading, and cascade liquidations are the core mechanism behind sharp market moves in cryptocurrency. High open interest and extreme position skew are precursors to cascades, and liquidation heatmaps help identify potential liquidation zones. Managing liquidation risk through low leverage, stop-losses, and isolated margin is the survival strategy for derivatives trading.
Next article: Mark Price and Index Price - The Standard for Fair Pricing