Liquidations: How and Why Positions Get Closed

A liquidation is the forced closing of a position by an exchange or protocol when a trader no longer has enough collateral to keep it open. Liquidations happen in leveraged trading, both in futures markets and in DeFi lending. Headlines about a wave of liquidations are common, and the mechanics behind them are worth understanding.

Why liquidations happen

When a trader opens a leveraged position, they put up only part of its value, called the margin. The rest is effectively provided by the platform. As long as the price moves in the trader's favor, nothing special happens. If the price moves against the position, the loss is subtracted from the margin. The platform has to close the position before the loss exceeds the collateral; otherwise someone else would have to cover the shortfall.

That is why every position has a maintenance margin, a minimum level of collateral. If the collateral falls to that level, the position is liquidated automatically.

Initial and maintenance margin

• Initial margin is the amount needed to open a position. The higher the leverage, the smaller it is relative to the position size.
• Maintenance margin is the minimum the collateral must stay above. It is usually a small percentage of the position size, and it varies by exchange and contract.

An important detail: many exchanges trigger liquidations based on the mark price rather than the last traded price. The mark price is a fair value that draws on data from several spot exchanges, which reduces the chance of being liquidated by a brief spike on a single venue.

A worked example

This is a hypothetical example that ignores fees and funding. A trader posts 1,000 dollars of margin and opens a long with 10x leverage, so the position is worth 10,000 dollars. Say the asset costs 100 dollars, which means the position holds 100 coins.

• If the price drops 10% to 90 dollars, the loss is 100 × 10 = 1,000 dollars, the entire margin.
• Liquidation comes earlier, though. Suppose the maintenance margin in this example is 50 dollars. The position is closed once the loss reaches 950 dollars, which happens after a 9.5% drop, at 90.50 dollars.

For comparison, at 2x leverage the same 1,000 dollars of margin opens a 2,000-dollar position, and the price would need to fall 50% to wipe out the collateral. The higher the leverage, the smaller the price move that leads to liquidation.

Isolated vs cross margin

• Isolated margin. Each position has its own dedicated collateral. If it is liquidated, the trader loses only that position's margin, and the rest of the account is untouched.
• Cross margin. The entire account balance backs open positions. This can delay a liquidation, but in a sharp move the whole balance is at risk.

What happens during a liquidation

The exchange closes the position at market or hands it to a dedicated liquidation engine. Traders are often charged a liquidation fee as well.

If the position is closed at a better price than the bankruptcy level, where the collateral would hit zero, the remainder usually goes into the exchange's insurance fund. If it closes at a worse price, the fund covers the loss. When the fund is not enough, some exchanges use auto-deleveraging (ADL), forcibly reducing some profitable positions on the opposite side.

Liquidation cascades

Liquidating a long position is essentially a forced sale, and liquidating a short is a forced purchase. When many traders hold similar positions with high leverage, one wave of liquidations can push the price further and hit the next group of positions. The result is a cascade, where the move feeds on itself. A burst of long liquidations is often called a long squeeze, and a burst of short liquidations a short squeeze.

This is why liquidation data and open interest are often used to judge how overheated the derivatives market is. They describe the current state of the market, not its future.

Liquidations in DeFi

DeFi lending protocols follow a similar logic. A user deposits collateral and takes out a loan. If the collateral value falls below a threshold, anyone, usually a specialized bot, can repay part of the debt and receive the collateral at a discount. Everything happens automatically according to the smart contract's rules, with prices supplied by oracles.

Key risks

• High leverage makes a position sensitive to even small price swings.
• In a fast market, the execution price can be worse than expected.
• Cross margin puts the whole balance on the line.
• Rules, fees and margin levels differ from one platform to another.

In short

A liquidation is an automatic safeguard that protects a platform from losses larger than a trader's collateral. When it happens depends on leverage, maintenance margin and the mark price. Mass liquidations can amplify market moves, which is why they show up in the news so often.