How to Avoid Getting Liquidated

How to Avoid Getting Liquidated

Getting liquidated is the last thing you want when chasing high returns. This guide outlines high-risk actions and shares tips on how to handle them. 

How to Avoid Getting Liquidated
Priscilla Thomas

Published Sep 1, 2022Updated Sep 1, 2022

Stock Trading

Stock Trading

Crypto

Crypto

Balanced Investing

Balanced Investing

Investing is one of the smartest things you can do for your future. Setting aside 10% of what you earn to build a well-diversified portfolio of assets has been a jackpot strategy for the last 50 years.

"When it comes to your finances, you want to increase the value of your investing account and liquidate debts. Not the other way around."

Almost every asset class has been on a straight-up-and-to-the-right journey if you zoom out on the charts. It's nearly impossible to lose, yet, many people have lost everything, some multiple times over.

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Chart of SPX from 1970-2022.

source: tradingview.com

While modern financial markets are some of the most surefire wealth builders in the history of the world, they can also be pocket casinos. Bells ringing, flashing greens and reds, hits, misses, and big scores—it’s like teleporting to Vegas through your phone. 

And that small screen doesn't mean small risk.

The two most important rules of successful investing are:

  1. Control your downside risk.
  2. Never invest more than you can afford to lose.

It’s easy to get carried away, especially with all the powerful tools at your disposal. But you aren’t really investing in your future if you keep getting liquidated. Trying to time the market, jumping in and out, using leveraged products improperly, and failing to manage position sizes are just a few ways can’t-lose investments become losers that you can't recover from. 

Let's take a look at how to avoid getting liquidated.

What does getting liquidated mean?

Getting liquidated happens when you borrow money or invest using a leveraged product (like options or futures), but the trade goes bad and you're forced to take heavy losses. 

When you invest with leverage, it means that, somewhere along the way, someone is lending you cash to invest. That doesn't mean you're on the hook with the goodfellas, but money borrowed is expected to be paid back. You probably won't be able to say that the Mafia liquidated your accounts, though. Whether that lender is your broker or whoever controls the asset you're investing in, purchasing a leveraged product means you're investing loaned money. As long as you have enough collateral, the lender will take the risk of that loan.

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Source: The Godfather (1972)

In most cases, your collateral is what’s in the trade and the cash in your brokerage account. If the trade goes south, your shrinking collateral may cause the lender to liquidate assets in your portfolio to protect themselves. This usually happens when the value of the collateral is close to the loan amount, and you can’t repay it in time. Once they terminate operations and take their loan back, you may be left with nothing—liquidated.

Example: The dreaded margin call

Let’s say you have $10k. You've seen Awesome Company stock skyrocketing lately, and you want to buy 100 shares at $100 each. But wait—your broker's offering a low-interest margin loan that would allow you to buy 200 shares instead. You’re sure Awesome Company's shares are going up, so why wouldn’t you buy twice as much?

But they don’t go up. Your golden stock plummets 50% in a week. That's bad enough, but it's not the worst of it. Your broker issues a margin call. They sold your position, all 200 shares for just $50 each. It was sold for a total of $10k, just enough to cover your loan. The lender is made whole, but you're left with nothing. That’s liquidation.

Liquidated damages

The above example accounts for the risks involved with just 2x leverage. Some crypto brokers allow 100x leverage on Bitcoin investments, which means it would only take a 1% drop to wipe you out.

Brokers won't usually wait for a stock to drop 50% before liquidating because they tend to keep a cushion on margin loans to protect their business and monitor risk. This means they'll probably ask you to pay the loan back much sooner in the case of a margin call.

A broker could also settle a margin call if your account balance drops below a certain level since they require a minimum qualifying balance for a margin loan. Drop below that minimum—even due to the investment you borrowed for—and your loan could be margin called. 

One thing that makes market sell-offs so violent is that each call creates more selling, and each sale pushes prices lower, which can trigger more margin calls. This devastating domino effect could leave countless retail investors with nothing but debts and dreams.

It’s not just borrowing that can get you liquidated. Your broker offers many powerful leveraged tools, including options and futures, that can help you maximize gains while minimizing losses when used correctly. But these tools in the hands of the overly eager or inexperienced investor can unleash chaos.

Often, avoiding liquidation can be as simple as staying away from products you don’t fully understand.

How can I get liquidated?

All investments require you to determine if the risk is worth the reward, but leveraged products add a lot to the risk side of the scale. Here are some high-risk tools that can put your assets on the line for liquidation. 

Futures

Futures contracts are for businesses that regularly need large amounts of a commodity. Futures contracts allow companies to make small down payments on large lots of goods with an agreement to pay the balance and take delivery on a certain date. This hypothetical company could be a farm that needs things like fertilizer or bushels of corn to feed livestock or an airline buying jet fuel.

With futures, a company can lock in a good's price at the right time without having to take the delivery immediately. This agreement helps a business better predict its costs, rather than paying whatever price is on the open market. This means a futures buyer can control large supplies of a commodity with a small amount of capital. In other words, futures are very leveraged positions, and small swings in price can mean huge gains and losses. 

This doesn't matter for a company looking to buy the whole lot eventually. But if you’re a futures trader just trying to make outsized gains on price movement, a trade that goes against you can wipe out your entire account in minutes.

Options

Options are much like futures, except they're usually for stocks instead of physical commodities.

An option contract allows you to buy or sell 100 shares of a stock at a specific price and date, regardless of the market price. If you’re holding 100 shares in a company, you can limit your downside by buying a put options contract that gives you the right to sell that stock at a set price no matter how low the market price drops. It’s like an insurance policy—costs a little bit upfront, but it protects you from catastrophe in the long run.

But, the very potent options are versatile, and you don’t need to own the underlying stock to use them. Trouble can happen when traders stop using options contracts as insurance and start trading them as assets in and of themselves. 

Options are complex; many things, such as the stock's price, the amount of time left before expiration, and how volatile the stock is, can affect its price. If you don’t understand how all these variables work together, options trading will quickly empty your accounts.

DeFi staking

In a crypto bull market, the gains in crypto and NFTs can make you rich. So it’s natural to want ways to be in more places.

If you’re into profile picture (PFP) NFTs, you might find that all your capital is locked up in JPEGs that you'd hate to part with. How’s a degen supposed to turn those Ape-y assets into cash without selling? Get a DeFi loan against that Punk, duck, or penguin. 

In DeFi staking, you often don’t need to prove that you can repay debt. There are no credit checks or verified accounts, and you don't even have to give personal information like your name. With DeFi, you're just interacting with a smart contract. 

Put your crypto or NFT up as collateral to get the liquidity you need to buy more crypto or make a bill payment. Volatility is the nature of crypto, and these loans can make it even more so. 

If you put your Bored Ape up as collateral and the floor drops too much, the smart contract will sell off your BAYC at rock bottom prices to cover your loan. No questions asked.

To avoid losing your top-dollar NFTs to a smart contract with an itchy sell finger, make sure you're depositing more crypto collateral or paying down your loan if you're getting close to that margin call. 

It’s easy to think you're safe because you have a small cushion only to have it and your Apes and Punk instantly evaporate. If other Ape owners are closer to the edge than you and end up getting their loans called, their Apes will hit the market for cheap. This could further drop the floor price and force your assets into the danger zone. 

Of course, minutes after the margin calls stop, prices usually recover, just without you.

How can I avoid getting liquidated?

Now that you know some of the ways you might get liquidated, it's understandable if you're feeling a little nervous. But before you empty all your funds and bury your cash in the woods for safekeeping, let's talk about how you can protect your holdings from liquidation. 

1. Make sure you only take on positions that you can handle 

All liquidations happen because someone took on a position that was riskier than they were prepared to deal with if it went wrong. Take on smaller position sizes so that you can better handle your business. If you cannot cover your debt, then your position size is too big.

Many futures contracts have mini versions which only involve a small fraction of the risk of a regular futures contract. 

Instead of trading naked options contracts, buy or sell them against an underlying stock position. This way, if you lose on the option, you win on the stock. This hedging strategy is a good way to limit your losses and better manage your trade.

You can also learn how to build options spreads that limit your downside if anything goes wrong. Platforms like Robinhood can help you make spreads that match your needs and risk profile.

robinhood
Robinhood

4.3

Stock Trading

2. Always use stop losses 

Know your limits. Even if you’re trading small, you need to know what you are willing to lose when going into a trade. Put differently, it means knowing when your trade was wrong. Once you know that, set a stop loss.

Stop losses are like safety harnesses for investors. These tools let you set a stop price where your position will automatically close. While that might mean you have to settle for missing out on potential gains, you'll also protect your assets if the price continues to fall.

Remember, half the battle of investing is not losing too much. If you can limit your losses, the gains often care for themselves.

You can find stop loss functions in crypto exchanges and guard your other assets with the stop loss tool on platforms like TradeStation and Public.

3. Have extra capital ready 

Markets can change fast. Even stop losses aren’t foolproof. Let's say you have a stop loss on a stock at $25. If the company closed one day at $27 but opened up the next day at $23, then it may not even trigger your stop loss. In this case, you can manage your position to avoid liquidation.

In traditional finance, unless something catastrophic happens, you usually get 24 to 48 hours to add funds to your account before they sell. Margin calls are so named because your broker would give you a phone call to demand more cash before they began liquidating your position. These days, you get an email and a message in the app about your debts, but the idea still applies. Making a cash payment on your margin loan is a way to avoid liquidation.

4. Give yourself enough time 

Many investors have great ideas about what’ll happen, but their timeframe is often wrong. There’s nothing wrong with this, but trying to time the market is a fool's game. Give the trade enough time to work if your convictions are strong about a company or token. That may mean months when you're thinking weeks, but time in the market is a better strategy than timing the market.

Avoid the impulse to go all-in on leveraged options and futures bets that are nearing their expiration dates. Not only are you out of the trade just one day past the cutoff, but there’s also a good chance your asset value will go to zero.

Not using a stop loss, overusing leverage, mistiming the market, and trading too big are all recipes for turning your assets into cash for someone else’s wallet.

Risk & Reward

Risk & Reward

Are your positions leveraged?

Safe bets and measured risks

You can’t get liquidated if you don’t use leverage. Traders use leverage to push their gains to the highest levels possible. Even if they win big a few times, their bets eventually fall through.  On the other hand, successful investors concentrate on slow growth and small wins that add up to big gains over time. 

While all the tools discussed in this article have their place, misusing them can be the difference between responsible investing and gambling away your hard-earned cash. 

When it comes to your finances, you want to increase the value of your investing account and liquidate your debts. Not the other way around.