What does "liquidation" mean? An in-depth explanation of the causes of liquidation and how to avoid it [A must-read for beginners]

For many newcomers to the investment market, liquidation is the most frightening term. Simply put, liquidation means: when your investment position loses enough value that your account’s margin is no longer sufficient to maintain the position, the trading system will forcibly close all your orders. In other words, not only will you lose all your principal, but in some cases, you might even owe money to the broker. That’s why many investors dread the term “liquidation.”

Understanding the True Meaning and Mechanism of Liquidation

To truly understand what liquidation is, you first need to grasp the core logic of the margin system. When you trade with leverage, the broker requires you to deposit a certain amount of margin to open a position. This margin acts like an “entry ticket”—its purpose is to protect the broker and ensure you have enough funds to cover potential losses.

The process of liquidation occurs as follows:

• You choose to buy an asset and set a leverage multiple → As the market fluctuates, your position starts to incur losses → Losses grow, and your margin balance decreases → When the maintenance margin ratio drops to the platform’s minimum requirement (usually 30%) → The system automatically triggers a forced liquidation → All your positions are closed at once → If losses exceed your margin, your account balance becomes negative

This process often happens instantly, leaving no time for reaction. In other words, liquidation is not a voluntary decision but an automatic system-enforced action.

Which actions are most likely to trigger liquidation risk?

Not all trades will lead to liquidation, but the following behaviors are particularly risky:

Setting excessively high leverage

This is the most common cause of liquidation. Suppose you invest 100,000 yuan of capital with 10x leverage in a futures contract, equivalent to controlling a 1 million yuan position. At this point, if the market moves against you by just 1%, your principal loses 10%; if it moves 10% against you, your margin could be wiped out, leading to forced liquidation and margin calls.

Many investors start confident, believing they can control risks, but market movements often outpace expectations. That’s why beginners should start with low leverage to practice and build resilience against unexpected volatility.

Psychological biases leading to hold-on behavior

This is a common mistake among retail investors. When a position starts losing money, many hope “it will bounce back soon,” but then a gap down or black swan event occurs. When the market opens, brokers may liquidate at market price, resulting in losses far exceeding expectations.

Hidden costs and fee traps

Many overlook hidden costs in trading. For example, day traders who don’t close their positions within the same day may need to deposit additional margin the next day; or in options selling strategies, if volatility spikes (e.g., during elections or geopolitical risks), platforms may suddenly require additional margin, sometimes doubling the margin requirement. Without sufficient funds, this can trigger liquidation.

Liquidity risk and market gaps

Trading illiquid assets or during low-liquidity periods (like overnight sessions) can lead to large bid-ask spreads. You might intend to exit at 100 yuan, but due to lack of buyers at that price, your order executes at 90 yuan or lower, resulting in greater-than-expected losses.

Unpredictable black swan events

Major events like the COVID-19 pandemic or Russia-Ukraine war can cause continuous limit-downs. During such times, not only are investors unable to close positions, but brokers themselves may be unable to execute trades. This can cause your margin and principal to be wiped out, even leading to negative equity (owing money to the broker).

Do liquidation risks differ among cryptocurrencies, forex, and stocks?

Different investment products carry varying levels of liquidation risk. Understanding these differences helps you make smarter choices when selecting trading instruments.

High-risk nature of the cryptocurrency market

Cryptocurrency markets are the most volatile among all assets, with the highest risk of liquidation. There have been instances where Bitcoin fluctuated over 15% within a short period, causing many investors to be liquidated simultaneously.

Importantly, during crypto liquidations, not only is your margin cleared, but the virtual currencies you hold may also be liquidated or disappear because exchanges will directly settle all assets to cover losses.

Forex margin trading operational considerations

Forex trading seems simple—using small capital to control large positions—but this feature is also a risk factor. Forex contracts come in three sizes:

• Standard lot (1.0 lot): 100,000 units of base currency
• Mini lot (0.1 lot): 10,000 units
• Micro lot (0.01 lot): 1,000 units, ideal for beginners

Margin requirement formula: Margin = (Contract size × Lot size) ÷ Leverage

For example, trading 0.1 lot of a currency pair worth $10,000 with 20x leverage requires a margin of $500. When your account’s margin ratio drops to the platform’s minimum (usually 30%), the system will forcibly close your positions—commonly called a “margin call.” If your account only has $50 but losses reach $450, the system will automatically close all positions, resulting in liquidation.

Stock trading and liquidation scenarios

Stock trading risks depend on your trading method:

Cash (spot) trading: No liquidation risk—since you buy stocks with your own funds, even if the stock price drops to zero, you only lose your principal; you won’t owe money.

Margin trading or day trading: The risk is higher.

• Margin trading: Borrowing money to buy stocks. If your maintenance margin falls below a certain level (e.g., 130%), the broker issues a margin call, requiring you to deposit more funds. If you cannot, the broker will forcibly sell your stocks to cover the debt.

• Day trading: If you open and close positions within the same day, the risk of liquidation is minimal. But if you hold positions overnight and the stock gaps down sharply, and you cannot sell in time, the broker may liquidate your holdings, leading to forced closure.

How to manage risks to avoid liquidation?

Having understood what liquidation is and its causes, the next step is to learn how to prevent it. The most effective method is to establish a comprehensive risk management system.

The importance of setting stop-loss and take-profit

Stop-loss is an automatic order to sell when your position reaches a certain loss level, preventing further losses. Conversely, take-profit is an automatic order to close a position once it reaches a target profit level.

These tools are the last line of defense to protect your capital. Properly setting stop-loss limits your maximum loss per trade, while take-profit ensures you lock in gains. Combining both helps maintain disciplined trading.

Many traders end up liquidated because they fail to set stop-loss orders, holding onto losing positions in hope of reversal, until the inevitable happens.

Calculating and applying risk-reward ratios

The core idea of risk-reward ratio: “Your potential reward should outweigh your risk.”

Calculation:
Risk-Reward Ratio = (Entry Price – Stop-Loss Price) ÷ (Take-Profit Price – Entry Price)

For example, if you buy at 100 yuan, set a stop-loss at 95 yuan, and a take-profit at 110 yuan, then:
Risk-Reward Ratio = (100 – 95) ÷ (110 – 100) = 5 ÷ 10 = 1:2

This means risking 1 yuan to potentially gain 2 yuan. A favorable ratio like this requires a winning probability above 33% to be profitable in the long run. The lower the ratio, the higher the win rate needed.

Using technical analysis to set stop-loss and take-profit levels

Experienced traders often use support and resistance levels, moving averages, and other technical indicators to precisely determine stop-loss and take-profit points. These levels reflect market psychology and key price points.

If you’re a beginner, a simple percentage method works well: set stop-loss and take-profit at a fixed percentage from your entry price—say, ±5%. For example, buy at 100 yuan, set stop-loss at 95 yuan, and take-profit at 105 yuan. This approach automates discipline and reduces emotional trading.

The role of negative balance protection as a safety net

Regulated brokers are required to provide negative balance protection—meaning you cannot lose more than your account balance. Even in extreme market crashes, your account will not go into debt; the broker absorbs the excess loss.

While this mechanism protects retail traders, it has limitations. Some brokers may reduce leverage during high volatility to control risk. Therefore, negative balance protection is a safety net, not a license for reckless trading.

Practical advice for novice investors

If you’re just starting out, consider these guidelines:

1. Begin with low-risk products: Use cash trading without leverage to limit potential losses to your principal.

2. Avoid excessive leverage: Even if trading leveraged products, keep leverage within 10x to maintain a safety margin.

3. Start with micro-lots: For forex, begin with 0.01 lot to familiarize yourself with market behavior before scaling up.

4. Always set stop-loss orders: No matter how confident you are, always define your exit point to prevent catastrophic losses.

5. Use dollar-cost averaging: For long-term wealth accumulation, regular investments reduce short-term volatility impact and lower risk.

Investing always involves risk, but the truly smart investors are not those who predict perfectly but those who manage risk effectively and survive in the market. Understanding what liquidation is, and how to prevent it, is essential for every investor. By establishing solid risk controls, setting reasonable stop-loss and take-profit levels, and choosing appropriate leverage, you can significantly reduce the risk of liquidation and trade more confidently and steadily on your journey.