Crypto Liquidation Explained: How Perpetual Futures Liquidation Works

Perpetual futures allow traders to speculate on the price of cryptocurrencies using leverage without directly owning the underlying asset. This allows traders to control and manage larger trading positions with less capital required upfront.

While that means leveraged futures can amplify profits, it also increases risk.

Perhaps the most significant risk when trading crypto perps is liquidation, the forced closure of a leveraged position when losses become too large and margin cannot be maintained.

Liquidation can happen quickly in volatile markets, especially as leverage increases.

Understanding how liquidation works, why clearing members use it, and how to reduce your chances of being liquidated are all critical to effectively managing risk while trading crypto perps.

What Is Crypto Liquidation?

Liquidation occurs when a clearing member automatically closes a leveraged position because there is no longer enough collateral or margin to support it.

When a trader opens a perpetual futures position, they deposit collateral that acts as initial margin. So long as the trade maintains a sufficient amount of margin, it remains open indefinitely. However, if the market begins to move directionally against the trade, losses will begin to reduce the available margin.

Once losses exceed the minimum required margin, or maintenance margin level, the position is closed by the clearing member on the exchange to protect both parties.

For example, a trader may open a 10x leveraged long position on Bitcoin expecting the price to rise. But if Bitcoin begins to drop, losses eat into the available collateral used to open the trade.

If Bitcoin falls enough and the losses become too steep, the maintenance threshold is breached, and the position is automatically closed or liquidated by the clearing member on the exchange.

Unlike selling a position or closing it voluntarily, liquidation is an automatic and forced procedure.

Why Does Liquidation Exist?

While liquidation may feel unfair at a glance, it exists for an important reason.

Liquidation prevents traders from losing more money than their collateral can cover.

All perpetual futures trades have a trader on each side, short and long, with one speculating on the price of an asset going down while the other believes it is going up.

The clearing member facilitates the trades, ensuring both sides of the contract are honored appropriately. If the clearing member allowed losing positions to remain open indefinitely, traders could owe more money than they deposited, therefore forcing the clearing member to take on bad debt, creating risk for other traders as well.

With liquidations, this behavior is prevented as perps positions are closed before losses can exceed the collateral available. This keeps crypto perpetual futures markets functioning appropriately.

What Is a Liquidation Price?

The liquidation price is the price at which point the clearing member will automatically close or liquidate an open leveraged position on the exchange.

Multiple factors determine the liquidation price, including:

• The entry price
• The amount of leverage
• How much collateral was deposited
• How the margin is allocated

The exact liquidation price calculation differs between exchanges. A full calculation will be found in our future guide on calculating liquidation price.

To get a better understanding of the relationship between leverage and margin in perpetual futures, refer to our guide which explains how the concepts work together.

Worked Example: How a Crypto Liquidation Happens

The easiest way to understand how and why a liquidation occurs is to walk through an example.

Assume a trader longs 1 BTC while it trades at $70,000. The trader chooses 10x leverage, and assigns isolated margin, putting down $7,000 of collateral as their respective margin. In this example, the exchange requires a maintenance margin requirement of 0.5%, meaning the trader will need to have at least $350 in margin (0.5% of the $70,000 notional value) to keep their position open.

Once the trade is opened, their position looks like this:

Upon opening, the trader maintains a $70,000 notional value position, but only had to deposit $7,000 of their own capital to do so because they decided to use 10x leverage. Additionally, because they are using isolated margin, their liquidation risk is limited to the collateral they’ve put up for this trade.

If Bitcoin remains relatively unchanged, the position will remain open. However, as Bitcoin begins to fall, losses can quickly mount based on the trader’s leverage.

Example Continued: Bitcoin Falls to $66,500

Assume that Bitcoin drops 5% from the trader’s entry price of $70,000 and begins to trade at $66,500. While the market has only moved 5%, the leverage significantly amplifies the impact to the open position, pushing the user’s losses to 50%.

At that point, their available collateral shrinks to approximately $3,500, with the other $3,500 is consumed by losses.

While the position is not yet liquidated, the trader has significantly less margin available to deal with any further losses. As Bitcoin continues to fall, the liquidation price of $63,317, nearly 10% from the entry position of $70,000, rapidly approaches.

Example Continued: Bitcoin Falls to $63,316

If Bitcoin falls nearly 10% from the entry price of $70,000 and reaches approximately $63,316, the trader’s collateral will have fallen below the exchange’s required maintenance margin requirement of $316.58, or 0.5% of the $63,316 notional value.

At this point, because there is not enough margin to safely support the position, the exchange automatically liquidates it.

Because the position is now closed, the trader no longer maintains exposure to Bitcoin’s price movements, even if the market later rebounds.

This example showcases the risks of leverage and liquidation. While Bitcoin only fell around 9.5% from the trader’s entry price, they still lost nearly their entire collateral because they used 10x leverage.

Higher leverage may increase returns, but similarly amplifies losses while reducing tolerable price volatility prior to liquidation.

Mark Price vs. Last Price in Liquidation

Futures exchanges typically use the mark price, not the last traded price of an asset to trigger liquidations.

The last price refers to the most recent trade on the exchange. But because individual trades can jump higher or lower than the broader market, an exchange relying on last traded price could allow spikes to trigger unnecessary liquidations.

Instead, using the mark price, which incorporates the spot price from multiple exchanges and adjusts for funding requirements, provides a more fair assessment of an asset’s value.

Additionally, using the mark price helps prevent any exchange manipulation in which a flash crash (or unusual price spike) on one exchange could lead to the liquidation of a position.

What Is Partial Liquidation?

Not all futures exchanges immediately close a full position upon liquidation.

Some exchanges will use partial liquidation, which reduces only a portion of a trader’s position as the margin level becomes too low. When the position size is decreased, it simultaneously decreases the amount of margin required to keep the position open.

This might give traders more time to add collateral while managing the position.

What Happens To Your Collateral During a Liquidation?

When an open futures position is liquidated, the collateral deposited by the trader is used to cover the losses on the position. For example, on Kalshi’s CFTC-regulated exchange, an opposing market order is placed as quickly as possible to close the position. If any margin remains after the close, it is returned to your account.

However in some instances, depending on the exchange and size of losses, remaining collateral after losses and fees may be placed into an insurance fund.

Note: Kalshi’s insurance fund is not subsidized or funded by trader liquidations.

What Is a Futures Exchange Insurance Fund?

Insurance funds are pools of capital that step in to absorb losses when liquidations are not able to fully cover them.

If the market is extremely volatile and moving so quickly that positions cannot be closed exactly at a liquidation price, a trader’s losses could extend beyond their remaining collateral. In that instance, the insurance fund is designed to step in with funds to cover the difference.

Without an insurance fund of some kind, those losses could then be passed on to other traders or create bad debt for the platform.

What Is Auto-Deleveraging (ADL)?

Exchanges may also use auto-deleveraging (ADL) as a risk management tool to prevent cascading liquidation events during volatile periods.

In this scenario, the exchange’s insurance fund may be depleted, and it begins to automatically deleverage or liquidate positions, often from the largest winners on the other side of losing trades to generate enough liquidity to close highly leveraged losing positions.

This is designed as a last-resort solution if insurance funds are unavailable during volatile periods.

How to Avoid Liquidation When Trading Crypto Perpetual Futures

While using leverage and trading crypto perps inherently comes with risk of liquidation, there are ways to limit the chances of being liquidated.

• Use lower leverage: Trading with lower leverage allows positions to sustain more volatile price periods without being subject to liquidation.
• Stop-loss orders: A stop-loss is a trading tool that allows users to set a point at which their position will be closed, stopping any future losses and avoiding liquidation in the process.
• Margin ratio monitoring: By routinely managing or monitoring available margin, a trader can react before price movements may move their position below the maintenance margin threshold.
• Using isolated margin: While using isolated margin does not reduce chances of liquidation, it does reduce the potential losses, allowing only the collateral assigned to a specific trade to be at risk. If that position is liquidated, the rest of your trading balance remains safe. However, in extreme instances, execution could happen at prices significantly worse than that expected to trigger liquidation. In some cases, this could lead to a negative account balance that the user is liable for bringing back to zero or a positive balance.

Frequently Asked Questions

Conclusion

Liquidation is one of the most important concepts to understand prior to trading perpetual futures. Though leverage can amplify gains, it’s important to note that it also magnifies losses.

When leverage increases, it also shrinks the price movements a position can sustain before being liquidated.

By understanding how the liquidation process works and learning about ways to help combat it, traders will be better prepared to participate in the rapidly growing world of perpetual futures trading.

This is not financial advice. Trading on Kalshi involves risk and may not be appropriate for all. Members risk losing their cost to enter any transaction, including fees. You should carefully consider whether trading on Kalshi is appropriate for you in light of your investment experience and financial resources. Any trading decisions you make are solely your responsibility and at your own risk. Information is provided for convenience only on an "AS IS" basis. Past performance is not necessarily indicative of future results. Kalshi is subject to U.S. regulatory oversight by the CFTC.