Are you new to the cryptocurrency world and wondering to know more about liquidation and have various myths in your mind regarding this concept? Well, liquidation is the process that enables traders to borrow funds and then sell assets but sometimes it goes worse and you have to face a big loss. In this article, we'll explore what liquidation is and how to avoid it. We'll delve into the management of liquidation as well as steps to avoid liquidation. This article is gonna help you whether you are a seasoned trader or just starting so without delaying more time let's get started!
What Does Liquidation Mean?
Generally, liquidation is a process that is typically used when a company, business, or organization becomes financially weak and they are not able to meet its financial obligations. In this case, they implement a liquidation process in their organization which means they sell off assets to pay off debts.
But in terms of crypto, liquidation is a process that occurs when a trader's position is liquidated and their assets are sold automatically by the exchange to pay off the debt and in return traders have to face a big loss. All this can happen suddenly due to the rapid change in the market or if the market changes rapidly.
In simple words, liquidation is a process when the traders trade with borrowed money and the value of the traded assets drops too much, in this scenario the exchange they are using will start the selling of assets automatically to pay the debt. All this happens when the traders don't have enough money for the trading and they borrow from various creators but fail to return debt timely.
Generally, Liquidation is of two types; the first one is Voluntary liquidation and the second one is Involuntary liquidation. Let's discuss both types one by one:
Voluntary Liquidation: In a voluntary liquidation, the upper body (Director) of the company appoints to the liquidator (the person who is responsible for the liquidation process) to sell all the company's assets and wind up the operation done by those assets, in that way they earn some amount and pay to debt. Voluntary liquidation occurs when the director of the company has realized that the company can not be run more or the specific assets of the company are no longer beneficial for the desired operations.
Involuntary Liquidation: Involuntary liquidation is also associated with compulsory liquidation, in this process, the liquidator is appointed by the court instead of the director because the involuntary liquidation company has no more control over their assets so that's why they cannot appoint a liquidator on their own. Only the court has the power to sell their assets and pay the debt or manage the liquidation process. Involuntary liquidation occurs when the company is not able to pay debt timely to its creditors.
In terms of crypto, there are also two types of liquidation; the first one is long-term liquidation and the second one is short-term liquidation. Let’s discuss both of them one by one and also relate them to general liquidations.
Long Liquidation: Long liquidation happens when traders borrow money to buy an asset but after purchasing the asset's value become down, causing the traders don't have enough money to pay the loan back to the creditors.
Short Liquidation: Short liquidation means when the traders borrow a cryptocurrency based on their personal thought and analysis and they think the price of that specific crypto will go up but in reality, it goes opposite to their thoughts, and the price of digital assets has gone down. In this case, they don't have enough money to pay back their creators and the sudden dip can cause a big loss.
How to Avoid Liquidation?
To get rid of loss you must know how to manage the liquidation so here few tips and tricks to avoid it:
- Set the Leverage of Amount: Only use a leverage amount that you can easily afford because sometimes high leverage may gain lavish profit but always keep in mind loss will also exist parallelly.
- Technical Analysis: Always keep an eye on the value of assets as well as you have vast knowledge about the asset's price rise and dip.
- Portfolio Diversification: Never put all your money on single assets, always invest in different assets so that you have less chance of loss.
- Risk Management Tools Utilization: Use the risk management tools to reduce the risk of liquidation. These tools are provided by your exchanges such as stop-loss orders, margin call notification, automatic liquidation protection, trailing stop-loss orders, hedging, and risk management calculator.
- Keep Adequate Funds: You must have enough funds in your accounts to cover the potential losses
Final thoughts, liquidation is a process in which the exchange sells a trader's digital assets automatically in the case when they fail to return the debt to their creators. LIquidation could be long-term or short-term, both have their risks and losses. To avoid liquidation traders should manage liquidation using stop-loss orders, margin call notifications, automatic liquidation protection, trailing stop-loss orders, hedging, and a risk management calculator.