What exactly is a liquidation? Recognizing the risks is essential for stable investing [Margin Trading Must-Read]

Everyone with investment experience has heard of the term “liquidation” (爆仓). It’s like the Damocles sword hanging over leveraged traders. A moment of carelessness can cause your hard-earned money to evaporate instantly, and you might even owe the broker—this is not sensationalism but a real tragedy that happens to countless investors. What exactly does liquidation mean? Why is high leverage operation particularly dangerous? How can scientific risk management help avoid a crash? This article explains it all.

What does liquidation mean? Core mechanism analysis

Liquidation, in the simplest terms, is: your trading direction is wrong, resulting in losses that cannot cover the margin, leading to forced closure of your positions by the system.

Specifically, when you engage in leveraged trading, you use a smaller amount of principal (margin) to control a larger position. If the market moves against you, and your net worth falls below the broker’s minimum margin requirement, the system will automatically close all your positions, leaving no chance for you to recover. This is the entire process of liquidation.

What are the main causes of liquidation? There are two:

1. Trading in the wrong direction versus market movement
2. Losses depleting your margin below the maintenance margin requirement (your equity falls below the required level)

Five common liquidation traps

1. Setting leverage too high

This is the number one killer of liquidation. Leverage is like a double-edged sword; it can amplify profits but also magnify losses. For example:

Using 100,000 yuan of capital with 10x leverage on Taiwan index futures, controlling a position worth 1 million yuan. If the market moves just 1% against you, your principal loses 10%; if it moves 10%, your margin is wiped out, risking margin calls or forced liquidation.

Many beginners overestimate their risk tolerance, but market changes are often faster than expected, leading to passive losses.

2. Overconfidence leading to excessive losses

Retail traders often make the mistake of holding onto the hope “it will rebound soon.” When the market gaps down sharply, brokers may liquidate positions at market price at the open, resulting in losses far exceeding expectations.

3. Hidden costs ignored

• Failing to close day trades (forgetting to leave positions open can incur additional margin requirements), causing a gap-up the next day that triggers liquidation
• Selling options when volatility surges (e.g., during elections), causing margin requirements to double suddenly

4. Liquidity risk

In less popular assets or during after-hours trading, bid-ask spreads are large, and stop-loss orders may execute at extreme prices. You want to stop at 100 yuan, but the market only has buyers at 90 yuan.

5. Impact of black swan events

Unexpected events like the COVID-19 pandemic or Russia-Ukraine war can cause continuous limit-downs, sometimes making it impossible for brokers to close positions. When the margin is exhausted and losses accumulate, you may owe money, facing the risk of being forced to cover.

Comprehensive overview of liquidation risks across different assets

Highest liquidation risk in cryptocurrencies

The crypto market is highly volatile, making it a high-risk zone for liquidation. Bitcoin has experienced daily swings of 15%, causing many investors to be liquidated. The key point is that during crypto liquidation, not only is your margin wiped out, but the coins you hold can also disappear.

Logic of liquidation in forex margin trading

Forex is a game of playing big with small money. Before understanding liquidation, you need to grasp a few concepts:

Contract sizes are three types:

• Standard lot: 1 lot
• Mini lot: 0.1 lot
• Micro lot: 0.01 lot (best for beginners)

Margin calculation formula: Margin = (Contract size × Number of lots) ÷ Leverage

For example, placing an order with 20x leverage for 0.1 lot of a currency pair (worth $10,000): Required margin = 10,000 ÷ 20 = $500

When your account’s prepayment ratio drops to the platform’s minimum requirement (usually 30%), the broker will forcibly close your position. For instance, if you have $50 left but need to maintain $150, the system will automatically close your position—that’s liquidation.

Stock margin trading and day trading liquidation scenarios

Trading stocks with cash only is safest: Using 100% of your own funds to buy stocks means even if the stock drops to zero, you only lose your principal, with no debt.

But margin trading and day trading can lead to liquidation:

Margin buying (borrowing from the broker) with a maintenance ratio below 130% will trigger margin calls. For example, using 600,000 yuan of margin to buy 1 million yuan worth of stocks, a 20% drop in stock price will meet the margin call threshold.

Failing in day trading and holding positions overnight, if the stock gaps down and hits the limit-down, you may not be able to sell, and the broker will liquidate your position, leading to liquidation if margin is insufficient.

Risk management tools: lifesavers in trading

To survive longer in leveraged trading, you must learn to use risk management tools.

Importance of stop-loss and take-profit

Stop-loss (cut-loss) is setting an “automatic sell price”—when the stock price hits this level, the system automatically sells, preventing further losses. Take-profit (profit target) is setting an “automatic profit-taking price”—when the stock reaches this target, it automatically locks in gains.

These two functions help you control risk and prevent total losses.

Risk-reward ratio = (Entry price - Stop-loss price) / (Take-profit price - Entry price)

The lower the ratio, the better. For example, risking 1 yuan to make 3 yuan results in lower risk and more stable returns.

How to decide stop-loss and take-profit levels

Experienced traders often analyze support and resistance lines, moving averages, and other technical indicators. Beginners can use the “percentage method”: set 5% above and below the purchase price. This way, you don’t need to watch the screen all day but can still manage risk effectively.

Negative balance protection mechanism

Regulated exchanges are required to provide negative balance protection. Simply put, you can only lose your account balance; you won’t owe the broker money. When losses reach the bottom, the remaining deficit is borne by the broker.

Some brokers proactively reduce leverage before major market moves to prevent huge losses. This protective mechanism is mainly designed for beginners, giving amateurs room to make mistakes.

Investment advice for beginners

First stage (beginner):

1. Practice with cash stocks, buy with spare money, so you won’t get margin called
2. Avoid all leveraged products; futures and contracts are for advanced traders

Second stage (advanced):

1. If you insist on trading contracts, start with micro lots (0.01 lot)
2. Keep leverage below 10x
3. Always set a stop-loss—never stubbornly hold against the market

Summary

Investing involves profits and losses, and leverage trading is no exception. Before engaging in margin trading, fully understand what liquidation means, how it occurs, and develop good habits like setting stop-loss and take-profit levels, and controlling leverage. The market is always there, but your principal won’t grow automatically—only through scientific risk management can you survive longer in trading. Remember, staying alive and making money is always more important than going all-in once.