Leverage and Liquidation Mechanics

Leverage amplifies gains but disproportionately increases the risk of total capital loss. Without strict controls, market volatility will force liquidation before the thesis plays out. This note explains position sizing, stop usage, and buffer management to survive leverage.

The Mechanics of Liquidation

Exchanges lend you funds to increase your position size. This debt is secured by your collateral, which is your margin. If the market moves against you and your equity drops below the maintenance margin threshold, the exchange forcibly sells your assets to repay the loan. This event is liquidation. Higher leverage brings the liquidation price dangerously close to your entry price. I view liquidation as a technical failure, not bad luck.

Position Sizing and Equity Risk

Most traders size positions based on their margin balance. This is incorrect. Size positions based on your total account equity and your risk tolerance. A common rule is risking no more than 1% to 2% of total equity on a single trade. If you have $10,000, your stop loss should not cost more than$200. This ensures that a string of losses does not destroy your capital. Leverage does not change this math; it only changes the position size relative to the collateral.

Stop Discipline and Execution

Mental stops are prone to failure. Under stress, you will hesitate. You must place hard stop-loss orders on the order book. Place stops below technical support levels, taking into account market noise. Be aware that stop markets guarantee execution but not price. In a flash crash, slippage may occur. However, slippage is preferable to a total liquidation. A stop is an insurance premium; pay it.

Maintaining Margin Buffers

Never use 100% of your available buying power. This leaves no room for error. I recommend maintaining a buffer of at least 30% to 50% unused margin. This buffer absorbs price wicks without triggering a margin call. Think of this buffer as operational overhead. Markets are irrational and violent. Extra margin keeps you in the trade during temporary dislocations.

Handling Volatility Spikes

When volatility spikes, spreads widen and liquidity often evaporates. Prices may wick down or up violently to hunt stop orders. Do not add to a losing position (martingale strategy) during these spikes. It is a gamble, not a hedge. If volatility exceeds your model's parameters, reduce leverage or close the position entirely. Survival is the primary objective during chaos.

Practical Risk Checklist

Review this checklist before opening a leveraged position.

• Calculate the exact liquidation price before opening.
• Ensure the position risk is ≤ 2% of total equity.
• Set a hard stop-loss order immediately after entry.
• Verify unused margin buffer is > 30%.
• Confirm the funding rate and maintenance margin requirements.

Next Step: Open a trading calculator and simulate a 5x leverage trade. Identify the liquidation price and calculate the loss if the price drops 10%.