Risk Management in Cryptocurrency Trading
When trading cryptocurrency, one has to be aware of the possibility of risk, and accordingly, how to properly manage that risk. Risk management should be a high priority for anyone looking to find success trading cryptocurrency, as it leads to managed losses, which eventually results in higher profits in the long term. Let’s take a look at some risk management techniques that you can implement in your tool kit to become a better trader.
In order to implement proper risk management techniques, we first need to understand the different forms of risk that can exist when trading cryptocurrency, for example:
Market Risk – this is the risk that appears when you enter into an open position. There is the risk that if you open a long position, the market can move in a downward direction, which would result in you losing your trading amount.
Regulatory Risk – this is the risk that comes from the regulatory uncertainty that currently exists in the cryptocurrency market. For example, when China banned initial coin offerings (ICOs) in 2017, it triggered an immediate sell-off of in the wider cryptocurrency market. Other examples of this risk could be the cryptcurrency exchange that you trade on being banned in your country. Right now, there are certain trading services that are not available to US-based traders.
Liquidity Risk – this type of risk appears when it is hard for a trader to liquidate their earnings into fiat currencies (e.g. USD, EUR, GBP and more). In this instance, a trader would find it difficult to actually spend their returns in day-to-day life.
Operational Risk – this type of risk is particularly relevant for cryptocurrency exchanges. For example, the exchange may make it difficult to actually withdraw your trading capital out of the exchange.
Now that we have a better idea of the types of risks that a trader could potentially face when trading cryptocurrency, we are then able to think of measures that we can adopt to mitigate these risks. For example:
Reducing Market Risk – we will get into how we can manage market risk further into the article. However, the best starting point is to learn about how to protect yourself to mitigate losses that can occur when the market moves in the opposite direction to your trade. For example, setting stop losses is a very easy way to mitigate losses.
Reducing Regulatory Risk – we can mitigate this type of risk by ensuring that our activities are compliant with the national regulatory laws of our country. We can also ensure that we stay up-to-date with the latest news to get an idea of the direction in which the cryptocurrency space is being regulated. If the government is not being too friendly with the cryptocurrency space, then it makes sense to stay out, until you get a clearer picture.
Reducing Liquidity Risk – the best way to mitigate liquidity risk is to make sure that you are only dealing with cryptocurrency exchanges that are reliable, so that you will not have any difficulties getting your money out of the cryptocurrency market. Another way is to make sure that you do not have any amount of money in the cryptocurrency space in excess of what you need to conduct your activities. For example, if you are trading with $10,000 and you generate about $2,000 in profit, make sure that you take out that $2,000. This way, only the $10,000 is at risk, not $12,000.
Reducing Operational Risk – operational risk can really only be mitigated by dealing with websites/companies that are reputable and have a track record of delivering good service for their customers. Therefore, reading online reviews is a good way of judging if a company/website can be trusted.
Risk Management Techniques
Implementing successful risk management techniques is all about preparation. That is why good traders live and trade by the saying: ‘plan the trade and trade the plan’. Let’s take a look at some techniques that you could be incorporating into your current trading plan.
Stop Losses and Take Profit Targets
We touched very briefly on this earlier in the article, but all traders should be incorporating stop losses into their trades. As well as this, traders should also be using take profit targets. To be a successful crypo trader, you need to be aware of the price that you are willing to exit your position if the trade doesn’t go your way (stop loss) and the price that you are willing to take profit if the trade does go your way (take profit target). Automated setups and signal groups (e.g. Binance signals) allow you to place your entry price, take profit target and stop loss before entering into the trade to mitigate trade risk.
Traders that do not plan this beforehand will become susceptible to making emotional decisions when they do place a trade. Emotional trading should be avoided at all costs, as it will result in sub optimal decision making that can lead to big losses or smaller returns. Trading is a long game, so the goal should be to reliably and consistently generate returns. This isn’t possible with emotional trading.
The position sizing risk management technique suggests that you should never risk more than 1% of your trading account on any single trade. As mentioned before, trading is a long game, and this technique is intended to keep you in the game over the long term. If, for example, you go on a 20-trade losing streak, you will still have 80% of your initial trading balance. The other benefit to this technique is that if you do go into a losing streak, because you are fixed at 1%, you will be using a lower proportion of your initial trading balance with each trade (as you will be using 1% of a reducing trading balance). Conversely, if you go on a winning streak, you will be using a higher proportion of your trading balance (as you will be using 1% of a growing trading balance).
Another important risk management technique is being able to weigh up the risk to reward ratio of placing a trade. The idea behind risk to reward ratio is to determine the expected return of a trade compared with the expected risk of placing that trade.
The risk to reward formula is as follows:
(Target – entry)/(entry – stop loss)
You can also use the below as a rough guide for determining the risk to reward of a trade:
- If it’s lower than 1:1 never place a trade
- 1:1 is breakeven
- 1:2 is great to trade
- 1:3 is even better and is an ideal ratio
The risk management techniques explored in this article are just a few strategies that you can be using with your trading. It’s important to carry on learning about other risk management techniques. Above all, take risk management seriously and you will begin to see more consistency in your trading.
Thank you for reading and sharing this article. Stay safe and healthy!
Elliot is a crypto-enthusiast that has been in the community for the past few years now. Elliot loves writing about trading and the technological developments in the crypto-space. When Elliot isn’t learning about crypto, you can find him reading a good book or on a run!
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