OptiNod Academy

Liquidation Cascades: When Liquidations Trigger More Liquidations

A large part of a sharp selloff is not driven by new information. It is a liquidation cascade: forced mechanical selling that pushes price too far before it snaps back.

A liquidation is the forced closure of a leveraged position. When price moves against a leveraged trade and margin falls below a required level, the exchange closes the position at market. When a long is liquidated, market sell orders hit the book. When a short is liquidated, market buy orders hit the book.

The problem is that forced selling pushes price even lower. As liquidated longs send market sells into the book, price drops further and hits the liquidation prices of the next group of longs below. Liquidations triggering more liquidations is called a liquidation cascade.

When traders see a sharp drop, they usually look for a reason. They ask what bad news came out or who sold. But much of a major selloff is a mechanical unwind of leverage that was already built up in the market.

That mechanical nature matters. Forced liquidations do not care whether price is expensive or cheap. They execute at market. That is why liquidation cascades often overshoot fair value, flush too far, and then rebound quickly once the forced selling is exhausted.

Liquidations Force Market Orders

The higher the leverage, the closer the liquidation price is to the entry price. A 10x leveraged long is nearly wiped out after about a 10% move against it, and a 20x long can be liquidated after only about a 5% drop. That is why markets crowded with high-leverage positions can see a chain of liquidations triggered by even a small decline.

Liquidations are handled by the exchange at market, regardless of the trader's intent. Unlike a stop-loss, the trader cannot choose the execution price. The position fills against whatever liquidity is available at that moment. Liquidation selling can quickly consume bids and drive price down sharply.

Large positions may be liquidated all at once, or partially in stages depending on the exchange. Either way, unwanted selling is forced into the market. Exchanges maintain insurance funds to keep forced liquidations from destabilizing the market too much, but when the cascade is large, that buffer can still be insufficient.

Liquidations Trigger More Liquidations

Liquidation prices are not scattered randomly. They cluster below price levels where many traders entered. Longs opened around similar prices with similar leverage tend to have liquidation prices in similar areas.

When price reaches the first liquidation level in that cluster, forced selling begins. That selling pushes price down into the next cluster of liquidation levels. If this continues through several layers, a decline that would normally unfold over days can be compressed into minutes or hours.

These liquidation clusters are visible to some extent. Tools such as liquidation heatmaps show how much leveraged exposure would be liquidated at each price level. Large players often target these clusters, and price tends to be pulled toward them. This is also why liquidations often build up most heavily around obvious levels, such as just below a recent high or low.

Liquidation Cascades Overshoot and Rebound

August 5, 2024 was a textbook example. BTC fell from the previous daily close of $58,161 to $49,000 in a single day, a 16% intraday drop. Several days' worth of decline were compressed into one session, and leveraged longs were liquidated in waves along the way.

But BTC closed that day at $54,018. Price had fallen to $49,000 and then recovered $5,000 on the same day. Once the forced selling was exhausted, the oversold move snapped back. Three days later, BTC had recovered to $62,000.

Why does price fall so far? During a liquidation cascade, buyers temporarily disappear. Forced selling floods the market while bids in the order book thin out, so even modest sell flow can push price a long way. Once the selling stops and buyers step in at discounted prices, the empty order book refills quickly and price jumps.

The liquidity hunt discussed earlier and a liquidation cascade are two sides of the same event. A cluster of liquidation levels is a thick pocket of liquidity, and a liquidation cascade is a large-scale liquidity hunt that sweeps through that pocket all at once. That is why the price action often looks the same: a deep wick followed by a sharp recovery.

The Fuel Builds Up First

Liquidation cascades do not appear out of nowhere. Leverage must already be crowded on one side of the market. High funding and rising open interest are the fuel. The point from the previous article, that extreme funding is fuel for liquidations, carries directly into this topic.

After August 5, funding turned negative. Longs had been wiped out by liquidations, and shorts were now crowding in near the bottom. That opposite-side crowding became new fuel. Even a small rebound liquidated shorts and accelerated the recovery. Liquidation cascades clear out one-sided positioning, then build positioning on the other side, swinging price sharply in both directions.

One Coin's Liquidations Can Pull Down the Whole Market

Liquidations do not stay contained within one coin. If BTC plunges in a liquidation cascade, not only BTC longs but also altcoin longs are liquidated. Most altcoins move in the same direction as BTC, and leverage is often even higher in alts, so they tend to fall more than BTC.

On August 5, while BTC dropped 16% intraday, ETH fell 22%, and other alts fell even more. Accounts that felt diversified across several assets can still see every position liquidated at the same time in the same direction during a cascade. As discussed in the position sizing article, correlations make diversification weaker than it looks when liquidations hit.

How to Act During a Liquidation Cascade

Do not try to catch price while it is still falling in the middle of a liquidation cascade. In that moment, there is no way to know how much further the liquidations will run. Buying at $49,000 can still mean sitting through another leg lower.

The entry is the same as in a liquidity hunt. After a deep wick forms, look for the same candle or the next candle to close back above that wick. That close is the entry area, and the stop goes below the wick low. A downside liquidation cascade inside a larger uptrend is the best buying opportunity.

A liquidation cascade inside a larger downtrend is different. In that case, the sharp drop may simply be part of the downtrend. The bounce often ends quickly before price sells off again. Only look to buy liquidation cascades when the larger trend is up. When the larger trend is down, do not catch them.

How to Avoid Liquidation Cascades

The way to avoid becoming a target in a liquidation cascade is simple: use lower leverage so your liquidation price is farther away. Low leverage such as 3x or 5x puts the liquidation price far enough from entry that a single liquidation cascade is less likely to wipe you out.

Place stops away from the crowd as well. When everyone has liquidation prices around the same level, that level becomes the target of the cascade. If your manual stop is placed slightly away from that cluster, you can avoid standing exactly where the liquidation sweep hits. Reducing position size during periods of extreme funding is another form of the same defense.

Spot holders without leverage cannot be liquidated in the first place. For those willing to wait without leverage, the deep wick created by a liquidation cascade can become a chance to buy at a discount.

Entering the Liquidation Cascade Reversal

• [ ] Entry condition: The weekly chart is in an uptrend. On the daily chart or a lower timeframe, a sharp downside liquidation cascade creates a deep wick below prior support, and the same candle or the next candle closes back above that wick.
• [ ] Entry: Buy at the close of the candle that confirms the recovery.
• [ ] Stop-loss: Place the stop below the wick low created by the liquidation cascade.
• [ ] Invalidation: If price closes below the wick low, treat it as a real breakdown and exit.

Liquidation cascades are among the fastest and most frightening moves in the market, but they contain very little information. They are simply the mechanical unwind of built-up leverage. Once you understand that mechanical nature, a liquidation cascade changes from an event that sweeps you away into an opportunity you can wait for. Keep leverage low enough to survive the flush, then wait for the recovery setup.