Margin Calls and Liquidations
In one of our previous articles where we talked about Spot, Futures, and Sentient, we looked at the difference between Spot and Derivatives trading in cryptocurrency markets. Today, we are going to dive deeper into the different terms and what they represent.
The Spot Market
The spot market is the market used to exchange cryptocurrency assets. This means that the ownership of cryptocurrencies is immediately transferred between market participants, right after the transactions are executed. Once the transaction is complete, and regardless of whether the price goes up or down, you own that asset until you decide to sell it.
A Crypto Derivative
A crypto derivative is an agreement between two or more parties for the future price of a digital asset. The parties of this trade never own the asset and don’t exchange it like in the spot market. Instead, they speculate on its price whereby they agree to buy or sell the asset at a predetermined price and/or a specified time in the future.
Margin Calls and Liquidations
To understand Margin Calls and Liquidations we have to delve deeper into futures and leverage. A futures contract allows an investor to speculate on the direction of a cryptocurrency, either long or short, using leverage without ever owning the asset. Leverage is used by investors and traders to increase their exposure to the market, and gives them the opportunity to increase their profits with less capital. But, with leverage comes risk, as using too much leverage with no proper risk management may end up in a Margin Call.
A Margin Call occurs when the value of the balance in a trader’s account falls below a certain level, known as the Maintenance Margin, requiring the account holder to deposit additional funds or become Liquidated.
For example, if you took a long on Bitcoin at $20,000 with 125x Leverage and Bitcoin’s price dropped by 0.8% to $19,840, you would receive a Margin Call. At this point, your only option is to deposit more funds into your leveraged long to keep it open or lose your initial investment and become Liquidated. Using such high leverage is extremely risky as the price movement has to be minimal for you to receive a Margin Call.
Very few successful traders use such high margins due to the inherent risks outlined above. So, usually, significantly lower leverage is employed: If you short Bitcoin at $20,000 using 2x leverage the price will have to go up by 50% to $30,000 for you to receive a Margin Call and face the dilemma of increasing your leveraged funding or becoming Liquidated.
The Takeaway
In conclusion, Margin Calls and Liquidations occur when (usually high) leveraged longs and shorts do not use correct risk management tools, such as stop losses. Sometimes, even using a stop loss cannot save you from a Margin Call if the market participants manufacture a liquidation cascade. A liquidation cascade occurs when liquidations pile on top of each other, causing a sudden and aggressive change in price.
But if you feel like that’s too much risk for your appetite, then Sentient might be the right fit for you! Stay in the loop to give it a go once the beta rolls out!
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