How Leverage and Liquidation Work

Liquidation is the forced closure of a leveraged position, or a collateralised loan, by an exchange or protocol when your collateral is no longer enough to cover the risk. With leverage you control a position larger than the margin you put up. If the price moves against you and losses push your margin below a set threshold, the system closes the position for you, and you can lose most or all of the margin allocated to it.

In crypto you will meet liquidation in two places: futures and margin trading on centralised exchanges, and DeFi lending protocols. The logic is the same; the mechanics differ.

How does leverage work?

Leverage is the ratio between the size of your position and your margin. Open a $10,000 long with $1,000 of margin and you are using 10x leverage. A 1% drop in price costs the position $100, which is 10% of your margin. Leverage magnifies gains and losses by the same factor.

On paper, a 10% fall at 10x wipes out the whole margin. In practice liquidation arrives earlier, because exchanges require a minimum amount of margin to keep a position open, and trading fees and funding payments also eat into it.

Initial margin vs maintenance margin

Initial margin is what you need to open a position. Maintenance margin is the floor your margin must stay above for the position to remain open. When losses drag your margin below that floor, liquidation begins. For larger positions, exchanges typically raise the maintenance rate in tiers.

How to estimate a liquidation price

For an isolated-margin linear contract, a rough formula, ignoring fees, is:

• Long: Liquidation price ≈ Entry × (1 − 1/leverage + maintenance rate)
• Short: Liquidation price ≈ Entry × (1 + 1/leverage − maintenance rate)

Example: a 10x long from $100 with a 0.5% maintenance rate liquidates at roughly 100 × (1 − 0.10 + 0.005) = $90.50. The same trade at 20x would liquidate near $95.50, after a fall of only about 4.5%. The liquidation price shown on your exchange’s position screen includes its own fees and rules, so treat that figure as the one that counts.

Isolated vs cross margin

• Isolated margin: each position uses only the margin assigned to it. If it is liquidated, your loss is limited to that margin.
• Cross margin: your shared account balance backs every open position. A position survives longer, but when it does go, it can take a much larger share of your account with it.

Some exchanges offer an “auto-add margin” setting that can pull extra funds into an isolated position. And if your margin is itself a cryptocurrency, a fall in its price reduces your collateral too.

Why liquidation can trigger at a different price than the chart

Futures platforms usually trigger liquidation on the mark price rather than the last traded price. The mark price is derived from an index of spot prices across several exchanges, and its purpose is to stop a brief wick on one venue from liquidating traders unfairly. If you watch the last price on your chart, that explains why liquidation might arrive at an unexpected moment.

A stop order does not always prevent liquidation either. It may track a different price, and in a fast market it can fill well below the stop level. Our guide to order types explains the differences between stops.

How liquidation works in DeFi

On lending protocols such as Aave, borrowers post collateral worth more than their loan. Safety is measured by the health factor: (collateral value × liquidation threshold) / debt. When it falls below 1, the position can be liquidated.

Example: $8,000 of ETH collateral, a 75% liquidation threshold and $4,000 of debt gives a health factor of (8,000 × 0.75) / 4,000 = 1.5. If ETH falls and the collateral is worth $5,000, the factor drops to 0.9375. A third-party liquidator can then repay part of the debt and claim that amount of your collateral plus a protocol-set bonus. Because collateral prices come from oracles, the oracle price is what decides the outcome.

What happens after a liquidation?

On a centralised exchange, the liquidated position is taken over by the exchange’s liquidation engine and closed in the market. A liquidation fee is often charged on top, and large positions may be closed in stages rather than all at once. Exchanges keep an insurance fund to cover cases where a position is closed at a worse price than its margin can absorb. In extreme conditions where the fund is not enough, some exchanges use auto-deleveraging (ADL), automatically reducing profitable opposing positions. To see what happened, check the closed quantity, price, fee and remaining balance in your trade history.

What is a liquidation cascade?

In a sharp move, each forced closure adds market orders: liquidated longs become sells, liquidated shorts become buys. Those orders push the price further and drag more positions to their liquidation levels. Chain reactions like this are one of the main causes of the sudden, deep wicks crypto markets are known for, and the risk rises with volatility.

How to avoid liquidation

1. Use lower leverage. The lower the leverage, the further your liquidation price sits from your entry.
2. Prefer isolated margin. It caps your loss at the margin assigned to the position.
3. Set a stop order. It closes the position at a level you choose before liquidation does it for you.
4. Watch the liquidation price on your position screen. Funding and fees can move it over time.
5. In DeFi, keep your health factor well above 1. Adding collateral or repaying part of the loan raises it, but transactions can be delayed when the network is congested.

Can you be liquidated on a spot purchase?

No. If you buy a coin on the spot market without borrowing or leverage, it cannot be liquidated however far the price falls. Its value drops, but the coin stays in your account. Liquidation risk only appears when you use that coin in a margin account or pledge it as collateral for a loan.

Sources

• Aave: liquidation of debt positions
• Coinbase: margin and clearing mechanism
• Coinbase: mark price and position calculations