Why Stop Loss Orders Are Better Than Liquidations

In crypto it is common for traders to use their liquidation price as a stop loss. However this can be a costly endeavor. This article explains some underlying concepts that involve liquidation.

The most important terms used when talking about forced closing of positions are Bankruptcy and liquidation.

Bankruptcy and liquidation are terms often confused and used interchangeably, but these two terms are actually very different. While both could involve insolvency – the inability to meet debt obligations – they’re not interchangeable terms.

Bankruptcy price is the price at which a trader`s losses exactly equals the collateral they`ve deposited

Liquidation price is the price at which the exchange will begin to automatically close a trader`s position. This price will arrive slightly before the bankruptcy price is reached

Bankruptcy and liquidation prices are two of the most significant price levels a trader needs to be aware of when trading perpetual swaps. Your collateral, position size, position side, average entry price, and maintenance margin ratio can impact where these prices are relative to the current m ark price of the product.

Explain it to me like I am a 4 year old.:

Hank has purchased $40.000 worth of BTC/USDT. Hank has only deposited $10.000 worth of fiat. This means that Hanks' position is leveraged by 4x. If Hank would have bought spot, then the price would have to fall to 0 before losing his $10.000 collateral. But now with leverage and the margin used, BTC can drop much less before Hank loses his $10.000 collateral.

In order to find out where that liquidation price lies, one must understand what maintenance margin ratio means (mmr). This concept refers to how much collateral a trader must maintain before being forcibly closed, acting as some buffer for the exchange before their position becomes fully worthless.

To keep things simple, let's assume that the mmr is 3%, which means that the liquidation price of Hank lies at 7731.96, which is slightly higher then his bankruptcy price of $7.500. The spread between liquidation and bankruptcy price is the margin that exchanges need to pay for your loss as the liquidation engine takes over.

Closing words

The main takeaway of being aware of these factors, reveals the implicit cost you are paying for a high-leveraged position, as the higher your leverage, the higher fees you will pay, as well as running the risk of being auto-deleveraged in case of a large liquidation sequence. The higher leverage you use, the more fees need to be paid, as well as drawing your liquidation price ever closer.

Liquidation is an expensive process due to the factors involved and the way that the mechanics work, it remains forever cheaper to close out of your position manually or with a set stop loss above liquidation price, rather than using your liquidation price as invalidation of the trade.

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Disclaimer:

The information provided above is not financial advice but for educational and entertainment purposes. Please do your own due diligence or consult a financial advisor before investing in any digital assets.

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