Understanding the Difference Between Liquidation Price and Bankruptcy Price | by LBank Exchange | Jun, 2023

From the LBank blog.

Understanding the Difference Between Liquidation Price and Bankruptcy Price

To navigate the high-leverage and volatile cryptocurrency perpetual swap markets effectively, it is crucial to have a comprehensive understanding of both liquidation and bankruptcy prices.

The bankruptcy price denotes the specific price level at which a trader’s losses precisely match the collateral they have initially deposited. In other words, reaching the bankruptcy price implies that the trader has incurred losses equivalent to their total collateral, resulting in their position being closed.

On the other hand, the liquidation price signifies the price threshold at which the exchange automatically initiates the closure of a trader’s position. This price level is triggered slightly before the bankruptcy price is reached. Therefore, understanding the liquidation price is vital for traders to anticipate potential automatic position closures and help manage their risk accordingly.

This guide will explain the concept of liquidation and bankruptcy prices and how understanding it can help traders make more informed decisions in the highly-leveraged and volatile cryptocurrency perpetual swap market.

Liquidation price is the price at which margin balance falls below the maintenance margin. The margin balance is calculated as the sum of the wallet balance and unrealized profit and loss, while the maintenance margin represents the minimum required margin to avoid contract position liquidation.

In LBank futures, liquidation is conducted based on the mark price, which represents the estimated true value of the contract. The mark price incorporates the fair value of the asset, ensuring that unnecessary forced liquidation is avoided during market fluctuations. The latest price refers to the most recent price of the Futures contract. Evaluating the margin balance and maintenance margin ultimately allows traders to be aware of their risk exposure and take necessary actions to maintain sufficient margin levels. LBank’s use of the mark price helps prevent premature forced liquidation, providing a more accurate reflection of the contract’s value. Staying updated with the latest price allows traders to make informed decisions based on real-time market conditions.

(Margin Type: Isolated Margin)

For Buy/Long positions:

Liquidation Price (LP) = [Entry Price × (1 — Initial Margin Rate + Maintenance Margin Rate)] — (Extra Margin Added / Contract Size)

And for Sell/Short positions:

Liquidation Price (LP) = [Entry Price × (1 + Initial Margin Rate — Maintenance Margin Rate)] + (Extra Margin Added / Contract Size)

Please note:

  • Initial Margin Rate (IMR) = 1 / Leverage
  • The Maintenance Margin Rate (MMR) is determined based on the risk limit tier.

These formulas are used to calculate the Liquidation Price for both Buy/Long and Sell/Short positions in the Isolated Margin setting. The Liquidation Price represents the price level at which the position will be automatically closed to prevent further losses.

The bankruptcy price signifies the price level at which a trader’s collateral is completely depleted due to accumulated losses. It represents a point where all of the initial margin has been lost.

During the liquidation process, the position being liquidated will be closed at the bankruptcy price, indicating that the trader has effectively lost all of their initial margin. In the event that the final liquidation price of the position is more favorable than the bankruptcy price, any excess margin will be contributed to the Insurance Fund. Conversely, if the final liquidation price is worse than the bankruptcy price, the Insurance Fund will cover the shortfall and absorb the loss.

Understanding the concept of bankruptcy price allows traders to assess the potential risks associated with reaching this critical level. It emphasizes the importance of managing positions and risks effectively to avoid depleting the initial margin and potentially relying on the Insurance Fund.

Bankruptcy Price Calculation (Margin Type: Isolated Margin)

In the case of a Buy/Long position:

Bankruptcy Price = Entry Price × (1 — Initial Margin Rate*)

And for a Sell/Short position:

Bankruptcy Price = Entry Price × (1 + Initial Margin Rate*)

*Initial Margin Rate (IMR) = 1 / Leverage

Let’s consider an example where a trader holds a Long position of 1 ETH with an entry price of 2000 USDT and a leverage of 75x.

Calculating the Bankruptcy Price:

Bankruptcy Price = 2000 × (1–1/75) = 1973 USDT

In this example, the Bankruptcy Price for the Long position would be 1973 USDT. It serves as a critical threshold indicating that if the price falls below this level, the trader’s position would result in the loss of their initial margin.

When engaging in trading perpetual swaps, it is crucial for traders to have a thorough understanding of bankruptcy and liquidation prices. These price levels are of utmost importance as they directly impact a trader’s collateral, position size, position side, average entry price, and maintenance margin ratio, relative to the current mark price of the product.

It is worth noting that these prices shed light on the implicit cost associated with high-leveraged positions. By exploring the aforementioned formulas, one can observe that increasing leverage magnifies the significance of the maintenance margin within the initial margin buffer. As discussed in our comprehensive guide on insurance funds, crossing the liquidation price threshold leads to automatic closure of the position, resulting in the loss of the maintenance margin spread to the exchange.

Disclaimer: The opinions expressed in this blog are solely those of the writer and not of this platform.

This article came directly from the LBank blog, found on https://lbank-exchange.medium.com/understanding-the-difference-between-liquidation-price-and-bankruptcy-price-d3c32b6d3e4b?source=rss-87c24ae35186——2

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