Some crypto exchanges offering derivatives trading make huge profits from liquidating positions, but traders can avoid this by followi...
Some crypto exchanges offering derivatives trading make huge profits from liquidating positions, but traders can avoid this by following some simple rules.
Most traders do not understand how derivatives exchanges mitigate the risk of providing margin funds. Even in the trading environment, the prevailing opinion is that "winners get the money of the losers", but things are not as simple as they seem.
Traders Lose Funds - Exchange Assets Grow
Insurance funds were originally designed to protect clients' positions during periods of excessive volatility. However, some exchanges, such as BitMEX, show relatively stable accumulation in the insurance fund, despite the fairly frequent liquidations.
BitMEX Insurance Fund for BTC Futures. Source: cointrader.pro
The graph above shows that BitMEX's insurance fund (orange line, BTC volume) was virtually unaffected after $ 1 billion in purchases (longs) were liquidated on March 12.
Whenever a position is liquidated due to insufficient margin, the exchange is responsible for managing this risk and there are several ways to handle this process. Most derivatives marketplaces have decided to create an insurance fund to circumvent these difficulties.
This insurance fund profits from the liquidations of traders' positions at better prices than the prices of existing orders, creating a dubious incentive for more active order management.
Remember the margin
Using excessive leverage when trading futures contracts exposes your capital to unnecessary risk, as some exchanges are very aggressive in liquidating. To prevent this scenario, you can actively manage the position and its stop loss orders.
Not every derivatives exchange handles liquidation the same way, so it is very important to understand the process.
The mere existence of an insurance fund does not mean more security for exchange clients. It all depends on how this risk is managed in extremely volatile situations.
Let's take a quick look at how BitMEX was able to disrupt an impressive $ 190 million bank during massive liquidations of positions.
Liquidation as a means of protecting the exchange
In truth, high leverage orders tend to go bankrupt in volatile markets. For example, any position using 20x leverage or more must be forcibly liquidated after a 4.8% price change. A problem arises when the price of the underlying asset changes dramatically within a short period of time or as a result of a lack of market liquidity.
The only way the liquidation mechanism can close a client's bankrupt position is to execute a reverse order in the market for the same instrument. Eliminating a $ 10 million long position means the exchange must sell that amount in its backlog. Any deliberate loss in excess of the client's margin will prevent the exchange of funds.
Some exchanges have designed their insurance fund to provide some kind of buffer against such financial constraints, collecting profits from liquidations of client positions executed at a better price than the available liquidity allows.
Thus, exchanges offering derivatives for bitcoin have the opportunity to either withdraw funds from customers who performed a high-risk transaction (automatic holding of funds), or risk their funds and wait for the market to recover in order to allow the client to win back losses. The choice is obvious.
However, not every derivatives exchange handles liquidations the same, but the phase-out process used by several major exchanges is definitely a step in the right direction. It is, in fact, a more proactive approach that increases the chances of the position surviving in extremely volatile situations.
How to avoid liquidation
In order not to lose funds in liquidation, it is necessary to prevent its occurrence. The only way to achieve this is to manually enter a stop loss.
Most derivatives exchanges provide an approximate liquidation price for each position, so this price is not difficult to calculate.
Liquidation price of a futures contract. Source: Binance Futures
In the example above, the liquidation price for this long position is $ 4,327. The trader should place a sell stop order above this price to avoid liquidation, and it is also best to gradually decrease the position to prevent the possibility of getting into a high volatility situation.
There is no golden rule for calculating the stop loss margin of error, although a gap of $ 50 to $ 300 is often used. A stop loss order for a long position is a sell / short order, whereas a seller must place a buy order to decrease his position.
Close triggers should always be activated for stop loss orders. This will ensure that no additional position is created by mistake, and only this order will reduce your position.
Another often overlooked parameter is the trigger. There are three options: the last price, which is based solely on the futures contract level, the index price, which is calculated from the average spot price of benchmark exchanges, and the brand price, which is the sum of the index price plus an interest rate.
The latter pricing option should be avoided as future contracts may differ from the price of the underlying assets.
