Liquidation Price

In decentralized finance (DeFi) protocols like Aave, Compound, and MakerDAO, the liquidation price is the specific market price of a collateral asset at which a user's position becomes undercollateralized. This occurs when the loan-to-value (LTV) ratio exceeds the protocol's maximum allowable limit, triggering a liquidation event. At this point, a portion of the user's collateral is automatically sold, often at a discount, to repay the outstanding debt and protect the protocol from insolvency.

The calculation of a liquidation price depends on several variables: the initial collateral value, the borrowed amount, the liquidation threshold (the LTV ratio at which liquidation begins), and the liquidation penalty. For example, in a simple scenario, if you deposit 1 ETH (worth $3,000) as collateral to borrow $1,500 of a stablecoin with a 75% liquidation threshold, your position would be liquidated if the value of your ETH fell to approximately $2,000, as the LTV would then exceed 75% ($1,500 / $2,000 = 75%).

Monitoring your liquidation price is a fundamental risk management practice. Traders use liquidation price calculators and set alerts to avoid being liquidated. A cascade of liquidations in a volatile market can lead to a liquidation cascade or death spiral, where forced sales drive the asset price down further, triggering more liquidations. This mechanism is a core component of overcollateralized lending, ensuring the protocol remains solvent even if collateral values plummet.

The liquidation price is the specific market price at which a leveraged position becomes undercollateralized, triggering an automatic, forced sale (or liquidation) to repay the borrowed funds. This mechanism is a core risk-management feature in decentralized finance (DeFi) and centralized margin trading, designed to protect lenders from losses if the value of the collateral backing a loan falls too low. The price is calculated based on the initial collateral value, the borrowed amount (loan-to-value ratio), and the platform's specific liquidation threshold.

Calculation is deterministic. For a simple long position, the formula is: Liquidation Price = Entry Price * (1 - Initial Collateral Ratio) / (1 - Maintenance Margin Ratio). This shows how the price moves closer to the entry price as leverage increases. Key factors influencing it include the collateral asset's volatility, the loan's health factor (a common DeFi metric), and protocol-specific parameters. Traders must monitor this price closely, as market volatility can cause rapid approach.

When the market price hits the liquidation price, a liquidation event occurs. A liquidator (often a bot) instantly repays part or all of the outstanding debt in exchange for the collateral at a discounted rate, known as a liquidation penalty. This penalty, typically 5-15%, incentivizes liquidators to participate and covers system risk. The original trader's remaining equity, if any, is returned after the debt and penalty are settled, but high volatility can sometimes result in liquidation below the price and a total loss.

Managing liquidation risk is crucial. Strategies include using stop-loss orders (though these are not native to smart contracts), providing excess collateral, or employing hedging with derivatives. In DeFi protocols like Aave or Compound, users can deposit additional collateral to improve their health factor and push the liquidation price further away. Understanding this mechanism is fundamental for anyone using leverage, as it defines the precise point of maximum financial risk within a trading strategy.

The liquidation price is the specific market price of a collateral asset at which a borrower's position is deemed undercollateralized, initiating a liquidation event. This price is not static; it is dynamically calculated based on the initial collateral value, the borrowed amount (debt), and the protocol's liquidation threshold or loan-to-value (LTV) ratio. For a simple long position, the formula is often expressed as: Liquidation Price = (Debt * (1 + Liquidation Bonus)) / (Collateral Amount * LTV Ratio). This calculation ensures the protocol can recover the loan value plus a penalty by selling the seized collateral.

Understanding this formula requires breaking down its components. The collateral amount is the quantity of assets deposited (e.g., 10 ETH). The debt is the value of the borrowed stablecoins or other assets (e.g., $15,000 DAI). The liquidation threshold is the maximum LTV ratio the protocol allows before liquidation (e.g., 80%). The liquidation bonus (or penalty) is an incentive for liquidators, typically 5-15%, added to the debt they must repay. If the market price of ETH falls to or below the calculated liquidation price, the position's health factor drops below 1, and the liquidation process begins automatically.

In practice, users must monitor their health factor, a real-time metric derived from these same variables: Health Factor = (Collateral Value * LTV) / Debt. A health factor of 1.0 is the liquidation boundary. Proactive management, such as adding more collateral (topping up) or repaying part of the debt, increases the health factor and pushes the liquidation price lower, providing a larger safety cushion against market volatility. This mechanism is fundamental to the risk management of lending protocols like Aave, Compound, and MakerDAO.

Different protocol designs and position types alter the calculation. For leveraged yield farming or perpetual futures on platforms like GMX or dYdX, the formula incorporates maintenance margin requirements instead of LTV. Furthermore, using volatile assets as both collateral and debt (e.g., borrowing ETH against BTC collateral) creates a relative liquidation price based on the ratio between the two assets' prices. These variations underscore the importance of using protocol-specific calculators and understanding the exact parameters before opening any leveraged position.