Cascading Liquidations in Crypto? - What are They

Q: How do you avoid crypto liquidation?

Steps to avoid crypto liquidation: Use Lower Leverage Set Stop-Loss Orders Manage Risk Diversify Your Portfolio asset.

Jakob Brezigar
Last updated: 23.November 2023
Reading time: 6 min

Imagine you’re playing a game of dominoes, but instead of tiles, you’re using your piggy bank savings – welcome to the world of cascading liquidations in crypto! It’s like a game where the pieces fall faster than your ability to say ‘Oops!’ So, what exactly is a liquidation cascade? It’s a rapid chain reaction in the crypto market, where prices drop extremely fast for a particular crypto asset, where your assets’s value may depreciate in total overnight.

What does it mean when crypto is liquidated?

When crypto is liquidated, it means that the digital assets held in a trading position are sold off, usually automatically. This typically happens when the value of the collateral securing a leveraged trade falls below a certain threshold, necessitating the sale of the assets to cover potential losses.

Is liquidation good in crypto?

Liquidation in crypto can be seen as a double-edged sword. While it can protect traders from even greater losses by automatically closing a failing position, it also means that the trader loses their investment in that position. It’s often viewed negatively by traders as it indicates a miscalculation or poor market performance.

How do you avoid crypto liquidation?

Steps to avoid crypto liquidation:

Use Lower Leverage
Set Stop-Loss Orders
Manage Risk
Diversify Your Portfolio asset.

Key Takeaways

Cascading liquidations in crypto are a chain reaction of forced asset sales, triggered when leveraged trading positions fail to meet margin requirements.
High leverage, market volatility, and automated trading algorithms are primary contributors to the occurrence of cascading liquidation events.
Understanding the liquidation price in leveraged trading is crucial, as it marks the threshold where positions are automatically closed to prevent further losses.
Strategies to counter cascading liquidations include diversified investments, setting stop-loss orders, and cautious use of leverage.
The current crypto market’s rapid growth and volatility have increased the frequency of cascading liquidations, impacting market stability and trader strategy.

Cascading liquidations, a phenomenon increasingly prevalent in the volatile crypto markets, represent a chain reaction of forced liquidations usually observed in leveraged trading. When the value of collateral falls below a certain threshold, it triggers a liquidation event, leading to the selling of assets. This selling pressure can cause further price drops, leading to more liquidations – a domino effect that reverberates through the market. Understanding the mechanics behind cascading liquidations tend to be crucial for market participants to navigate these turbulent waters effectively.

What is a Liquidation Cascade?

A liquidation cascade in the crypto context is a rapid succession of forced liquidations. When traders take leveraged positions and the market moves unfavorably, these positions are closed by brokers or exchanges to limit losses. This action, however, can exacerbate market volatility. For instance, if a significant number of leveraged positions are liquidated, it can cause a sharp decline in asset prices, triggering further cascading liquidations. Such events highlight the inherent risks in leveraged trading within the market of crypto assets.

What does It Mean When Crypto is Liquidated?

What is Liquidation Price

Liquidation price is a critical concept in leveraged trading. It’s the price at which a trader’s position is automatically closed or liquidated to prevent further losses. In the world of crypto, where volatility is high, monitoring the liquidation price is essential. It acts as a safeguard, but also as an indicator of the risk level of a leveraged position. Understanding and managing the price of liquidation can be a key strategy to prevent becoming a part of a cascading liquidation event.

Our Most Significant Experience from Practice

When I think of cascading liquidations, the first thing that pops into my head is one of the largest BTC liquidation events. It was also the worst single day BTC drawdown, at -39% which happened on March 12th 2020. Traditional markets were derisking because of the COVID-19 pandemic fears, which soon spread into crypto markets. That was the day the market structure broke, resulting in $700 million in forced sell liquidations. At the time, the largest derivatives exchange BitMEX only accepted BTC as collateral for BTC perps. As the price of BTC was dropping, the value of the BTC collateral was also rapidly decreasing, forcing cascading liquidation to accelerate even more.

It was like an empty void, a true black swan event that caught off guard too many fund managers. Consequently they were wiped out and had to close their shops forever. We often use this event as a reference in our risk modeling, remembering that it is more important to keep our greed in check and live another day.

Why do Liquidation Cascades Occur?

Liquidation cascades occur due to the interconnected nature of financial markets, especially in crypto. With many traders taking similar leveraged positions, a significant price movement can affect multiple portfolios simultaneously. This synchronized impact often results in a cascade, as each liquidation exerts downward pressure on prices, leading to further cascades. Understanding these dynamics is crucial for market participants to navigate and potentially counter cascading liquidations.

What Causes a Cascading Liquidation?

Several factors contribute to cascading liquidations. Key among them is the high leverage used by traders in the crypto, which amplifies both gains and losses. Additionally, automated trading algorithms can accelerate the speed and volume of these liquidations. Market conditions, such as low liquidity or significant news events, can also play a role in triggering a cascading liquidation event. Understanding these triggers is vital for traders to mitigate risks.

What Causes Liquidation Cascades in Crypto?

Liquidation cascades are primarily caused by a confluence of high leverage, market volatility, and panic selling. In the crypto market, where fluctuations can be extreme, these factors often interplay to create a perfect storm. Leveraged positions, particularly those with a high liquidation price threshold, become vulnerable as market conditions shift, potentially leading to cascading liquidations that can impact the broader market.

Ways to Counter Cascading Liquidations

To counter cascading liquidations, traders and market participants can adopt various strategies. Diversifying investments and maintaining a balanced portfolio can reduce exposure to volatile assets prone to rapid price swings. Implementing stop-loss orders can also help limit losses before they trigger a cascading liquidation event. Moreover, being cautious with leverage and monitoring the liquidation price closely can prevent getting caught in these devastating chains.

If you would like a more detailed and personalised plan to counter such events and prevent your asset portfolio from depreciating uncontrollably you can always consult with us at Orcabay.

How do You Avoid Crypto Liquidation?

Steps to avoid crypto liquidation:

Use Lower Leverage: Opting for lower leverage reduces the risk of hitting the liquidation price.
Set Stop-Loss Orders: These orders can automatically close your position at a predetermined price to minimize losses.
Manage Risk: Regularly monitor and adjust your positions based on market conditions.
Diversify Your Portfolio: This can reduce the impact of volatility in any single asset.

Some of these steps are also helpful for safer investing in traditional markets.

Leveraged Staking Positions

Leveraged staking positions in crypto can significantly increase the risk of cascading liquidations. While leveraging can amplify returns, it also raises the stakes, making positions more susceptible to market volatility. A slight adverse move in the market can quickly bring a position close to its liquidation price, triggering a cascade. Traders should exercise caution and awareness of the inherent risks of leveraged staking in the market of cryptocurrencies.

Liquidation Cascades in the Current Crypto Market

The current crypto market, with its rapid growth and evolving landscape, has seen an increase in the frequency of cascading liquidations. Factors such as regulatory changes, global economic conditions, and technological advancements play a role in this. Market participants must stay informed and agile, adapting their strategies to the dynamic nature of the market to navigate and possibly counter cascading liquidations.

Is liquidation Good in Crypto?

Disclaimer: The information provided in this article is for informational purposes only and does not constitute financial, investment, or other professional advice. All opinions expressed herein are solely those of the author and do not represent the views or opinions of any entity with which the author may be associated. Investing in financial markets involves risk, including the potential loss of principal. Readers should perform their own research and consult with a licensed financial advisor before making any investment decisions. Past performance is not indicative of future results.