What is Contract Liquidation?
In contract trading, liquidation occurs when market prices change too rapidly or drastically, resulting in insufficient margin in a user's account to maintain the existing contract positions, leading to forced position closure and loss settlement. The principle of contract liquidation can be expressed by the following formula:
Margin Ratio = (Account Equity + Unrealized Profit and Loss) / (Contract Value × Leverage Multiple)
When the margin ratio falls below the maintenance margin ratio, the forced liquidation mechanism is triggered. The platform will automatically close all of the user's contract positions at the optimal market price, and deduct the corresponding handling fees and funding fees. If excessive market price volatility causes the closing price to fall below the bankruptcy price (the price at which account equity reaches zero), a liquidation loss will occur. This means the user will not only lose all their margin, but may also be required to compensate the platform or other users for losses.
Why Is Liquidation So Common?
The root cause of contract liquidation is market price movements that exceed the user's expectations and risk tolerance, resulting in insufficient margin to support contract positions.
Due to the leverage effect, contract trading carries extremely high risks. When the price moves against you, you need to close your position in a timely manner to prevent further expansion of losses. If you fail to close your position promptly, your margin will gradually decrease until it finally reaches the liquidation line. If your margin falls below the liquidation line, your positions will be forcibly closed, and all your funds will be liquidated.
Specifically, there are several common scenarios that lead to liquidation:
- Excessive Position Size: Some users choose high leverage multiples or large position sizes in pursuit of higher returns, resulting in a low margin ratio and large risk exposure. In this case, even a small reverse market movement can easily trigger the liquidation line.
- Failure to Set a Stop Loss: Some users choose not to set a stop loss or set overly lenient stop loss conditions to avoid being stopped out frequently or missing rebound opportunities, making it impossible to control losses in a timely manner. This can easily lead to liquidation in the event of extreme market volatility.
- Refusal to Admit Trading Mistakes: When faced with reverse market movements, some users are unwilling to admit errors in their judgment out of psychological denial or self-comfort, and instead continue to hold their positions or even add to them, leading to ever-expanding losses. This makes liquidation highly likely in the event of extreme market fluctuations.
How to Avoid Liquidation?
Leverage Control
So, what percentage of price movement will trigger liquidation in contract trading? The answer is: it depends on your leverage multiple and margin level.
For example, suppose you use $10,000 with 5x leverage to buy $50,000 worth of Bitcoin, which means you have put up 20% margin. If Bitcoin rises by 20% the next day, the value of your Bitcoin position becomes $60,000, and you earn $10,000. With an initial principal of only $10,000, this equates to a 100% rate of return.
Conversely, if Bitcoin falls by 20% the next day, you lose $10,000, wiping out your entire principal. If the price continues to fall, the funds lent to you by the platform will also be lost. For this reason, the platform will forcibly sell your Bitcoin to recover the lent funds and interest, which is forced liquidation. In this scenario, your money is gone, your position is gone, and you have no chance to wait for the price to rise back up — a complete liquidation.
In practice, for novice users participating in contract trading for the first time, when opening a position, you should choose an appropriate leverage multiple and position size based on your capital situation and risk tolerance, avoiding excessive greed or fear. Generally speaking, the margin ratio should be kept above 10%, and the leverage multiple should be kept below 10x.
Set a Stop Loss
Controlling leverage reasonably can avoid liquidation risk to a certain extent, but the crypto market is characterized by high volatility. Even with a controlled leverage ratio, you can still be liquidated by extreme market swings. Therefore, on the premise of reasonable position control, you also need to set a stop loss point/line.
A stop loss should be part of the exit strategy for every trade you make. These orders are executed once the price reaches a predetermined level, closing your long or short position to limit losses. Whether you prefer to trade using candlestick charts, trend lines, or technical indicators, with a stop loss in place, you never have to worry about exiting a trade or second-guessing your decision afterward.
For example, a trader who establishes a long position based on an ascending triangle can quickly determine where to set their stop loss. The height of the triangle's Y-axis provides a potential price target, while the hypotenuse of the pattern indicates the invalidation point.
We strongly recommend setting a stop loss/exit point for every contract trade, because no one knows what will happen in the cryptocurrency market on any given day. For this reason, stop losses help protect you from unforeseen circumstances and give you a clearer understanding of the expectations for every position you open.
Setting a stop loss is very simple when opening a position on BitTap. Enter the [Contracts] page, check [Take Profit/Stop Loss], and you can enter the [Stop Loss] price. BitTap's contract trading supports up to 20 stop loss orders, allowing you to protect the principal in your contract account with greater efficiency.
Suppose you purchase a BTCUSDT contract at a price of $10,000 in BitTap contract trading. To minimize potential losses from this trade, you can set a stop loss order at a price 20% below your entry price (i.e., $8,000). If the price of BTCUSDT falls below $8,000, your stop loss order will be triggered. The exchange will then sell the contract at the current market price, which may be exactly the $8,000 trigger price or significantly lower, depending on prevailing market conditions.
It is important to note that a stop loss is not a foolproof method to prevent forced liquidation. In the crypto market, the liquidation price can change, and setting a stop loss can only reduce the risk of liquidation, not completely eliminate the possibility of forced liquidation. For novice users, this may be the only "unfavorable" aspect. Therefore, before starting contract trading, you must first clearly define and fix the maximum loss amount you can accept. The most straightforward approach is "trade investment amount = maximum stop loss amount", meaning after evaluating the maximum loss you can accept for a single trade, you open your position based on that amount.
Capital Management
As we all know, capital management is a method of adjusting position sizes to reduce risk while maximizing the growth potential of your trading account. This strategy limits the capital allocated to any single trade to a set percentage of your account value. For novices, a ratio of 5%-10% is relatively reasonable. The dollar value in this range will rise or fall as your account value changes, and it ensures you do not overexpose your entire account to a single position.
Due to the unpredictability and volatility of cryptocurrencies, when investing in highly leveraged derivatives such as perpetual futures contracts, you can lose your entire investment principal in a matter of minutes. For this reason, investors should adhere to stricter limits; a rule of thumb when trading volatile assets is to risk only 5% and no more than 10% of your capital on a specific trade.
For example, suppose you have 10,000 USDT in your BitTap contract account. In this case, you would allocate a risk of 500-1,000 USDT to each trade. If the trade goes against you, you will only lose 5% or 10% of the funds in your account.
Good risk management means having the correct position size, knowing how to set and move stop losses, and taking the risk/reward ratio into account. A sound capital management plan allows you to build a portfolio that won't keep you up at night.
It is important to note that while capital management can reduce your risk, you must avoid overtrading at all costs. Overtrading occurs when you have too many open positions or risk a disproportionate amount of capital on a single trade, exposing your entire portfolio to excessive risk. To avoid overtrading, you must follow a trading plan and maintain the discipline to stick to your pre-planned strategy.
Most new traders are notorious for overtrading, which is often caused by a failure to control emotions such as greed, fear, and excitement. While traders can make huge profits by opening a large number of positions, the losses can be equally devastating. A prudent way to limit losses across all positions is to set a cap on the amount of capital you have at risk at any given time.
For example, if you hold 25 open contract trades at the same time, even if each contract risks 1% of your portfolio, (as almost anything can happen in the cryptocurrency market) all 25 trades could move against you simultaneously, resulting in a significant 25% loss to your portfolio.
In addition to the risk of each individual trade, you should also consider the cumulative amount of risk across your entire portfolio, also known as total risk capital. As a general rule, your total risk capital should be less than 10% of your portfolio. This means that if you risk 1% of your portfolio per trade, the maximum number of open contracts you should hold is 10.
Final Notes
In contract trading, the risk of liquidation is a challenge faced by every investor. For this reason, investors should learn how to avoid liquidation. The effective risk control measures introduced in this guide — setting a reasonable leverage ratio, defining stop loss points, and reducing risk through capital management — can help investors achieve more stable returns in contract trading. At the same time, before engaging in contract trading, it is recommended that investors familiarize themselves with the BitTap platform rules, market trends, and other relevant information to make accurate market forecasts.