Why should my stop loss be less than my liquidation price?
This is the question I was asked by one of my students. I know the question sounds rather obsolete especially to a veteran or a professional trader. But this student of mine identifies as a newbie and promised to make a post on it.
Liquidation price refers to the price level at which a trader's leverage trade is closed to avoid further losses. This occurs when the market moves against the trader's position to the extent that they no longer have sufficient funds to maintain their position. This leads to complete seizure of their asset by the exchange. All their funds will be wipe off.
Where as stop loss price is a predetermined price level at which a trader's leveraged position is closed automatically to limit or prevent potential losses.
The striking difference between stop loss and Liquidation is; stop loss minimises your loss. Liquidation wipe off your entire account.
Suppose you buy PENDLEUSDT at the price of $2.8. Let's assume your liquidation price is $1.9. Then you set your stop loss at $2.3. This means that when the price of pendle drops to $2.3 your position would be closed automatically with some loss but you still have some funds left in your account. On the other hand, if you opened same position at the same price with the same liquidation price but this you set your stop loss the same with your liquidation price. It means when your stop loss is hit all your would get wiped off. All your funds are gone.
The first image below iterates the importance of stop loss. If you set your stop loss at the red horizonta line. You are likely to encounter a loss of only $20. Without stop loss in place notice how the long red candle goes down. The second image I believe most of you are familiar with is that of a TRBUSDT. Look at how the price dropped down from $555 to $155 on the 1 day time frame. Millions of dollars got liquidted that probably because of high leverage and failure to put stop loss in place.
I hope this help.
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