Leveraging the power of margin trading comes with the risk of liquidation. This mechanism acts as a failsafe for both the trader and the DEX, automatically closing your position when your equity dips below a critical threshold. This is done to prevent further losses and protect the system's stability.
Liquidation is triggered when your account's maintenance margin drops below a certain level. This maintenance margin is a percentage of the total contract value, typically lower than the initial margin you deposited. It acts as a buffer against price movements.
Maintenance Margin Requirement
The margin must fulfill Margin >= InitialMarginRatio * Price * Quantity, e.g. in a market with maximally 20x leverage, the initial margin ratio would be 0.05. Any new position will have a margin which is at least 5% of its notional.
The margin must fulfill the mark price requirement:
Throughout the lifecycle of an active position, if the following margin requirement is not met, the position is subject to liquidation. (Note: For simplicity of notation but without loss of generality, we assume the position considered does not have any funding.)
For Longs: Margin >= Quantity * MaintenanceMarginRatio * Mark Price - (MarkPrice - EntryPrice)
For Shorts : Margin >= Quantity * MaintenanceMarginRatio * Mark Price - (EntryPrice - MarkPrice)
For example, let's say you use 10% margin for a Bitcoin futures contract worth $100,000. Your initial margin would be $10,000, and your maintenance margin might be 5% ($5,000). If the price of Bitcoin falls significantly, causing your equity in the contract to drop below $5,000, your position will be automatically liquidated.
How Does Liquidation Work?
When liquidation is triggered:
The exchange will force-close your position. This means selling your futures contract, regardless of the current market price.
The proceeds from the sale will be used to cover your outstanding debt to the platform. This includes the initial margin, any unpaid funding fees, and the loss incurred on the position.
Any remaining funds will be credited back to your account. However, it's crucial to remember that liquidation can potentially wipe out your entire initial margin deposit.
To avoid the painful sting of liquidation:
Monitor your margin: Keep a close eye on your account's margin level and the market movements affecting your positions.
Use stop-loss orders: These pre-set orders automatically sell your position when the price reaches a certain point, potentially minimizing losses and preventing liquidation.
Maintain adequate margins: Avoid over-leveraging your positions. Higher margins provide a larger buffer against price fluctuations.
Understand funding rates: Factor potential funding costs into your risk management calculations, especially in volatile markets.