Liquidation: What It Is and How It Works

How liquidation works on an exchange

When you trade with leverage, for example perpetual futures or margin trading, you post collateral (the initial margin) and control a larger position. The exchange also sets a maintenance margin: the minimum collateral the position must keep.

1. As the price moves against you, unrealized losses are subtracted from your margin.
2. The price at which the remaining margin would hit the maintenance level is the liquidation price. Exchanges measure it against a mark price built from spot indexes, so a brief spike on one venue does not trigger it.
3. When the mark price reaches that level, the exchange's engine takes over the position and closes it in the market. A liquidation fee is usually charged.

A rough rule of thumb: the higher the leverage, the closer the liquidation price. With 10x leverage, a move of roughly 10% against the position, minus fees and maintenance margin, is enough to lose the margin; with 50x, about 2%.

In isolated margin, only the collateral assigned to that position is at risk. In cross margin, the whole account balance backs all positions, which delays liquidation but can put more money at stake. If a liquidation closes at a worse price than the collateral covers, exchanges use an insurance fund or, in extreme cases, auto-deleveraging of profitable traders on the other side.

Liquidation in DeFi lending

On DeFi lending protocols such as Aave, users borrow against crypto collateral. Each position has a health factor or collateral ratio. If the collateral's value falls below the protocol's threshold, anyone (in practice, automated bots called liquidators) can repay part of the debt and receive the matching collateral at a discount, the liquidation bonus. The borrower keeps the loan proceeds but loses that slice of collateral.

Prices come from oracles, so an oracle error or a sudden crash can trigger liquidations quickly, and on busy networks liquidators compete through transaction fees and MEV.

Liquidation cascades and how to reduce the risk

When many traders use high leverage on the same side, a price move can liquidate the first group, whose forced selling (or buying) pushes the price further and liquidates the next. These cascades explain many of crypto's sudden wicks.

Traders reduce liquidation risk by using lower leverage, keeping extra margin, setting stop-loss orders that close a position before the liquidation price, and watching funding rates and open interest for signs of a crowded market. Leveraged products are high-risk; this is general information, not a recommendation to trade them.