“Investments are subject to market risks.” That’s a disclaimer commonly associated with the stock market, but the cryptocurrency market is no exception. Market risk is a challenge all crypto traders face.
Understanding risk management and its value is crucial for the success of crypto traders; those who fail to recognize the value of adhering to risk management strategies are likely to lose out. Read on to learn more about the different kinds of risks you too will face on your crypto trading journey and how you could manage them.
What is risk management in crypto trading?
Risk management refers to strategies a trader might use to manage losses and maintain a good risk–reward ratio. In the crypto market, which is notoriously volatile, risk management is especially crucial.
Traders need sound risk management because it helps them gain an edge in trading on the good days. And when crypto turns volatile and prices are dropping by the minute, risk management can help traders keep losses at bay, making survival and eventual success possible.
What is the importance of risk management?
Risk management is an important pillar of crypto trading; it supplements the trader’s larger strategy. When a trader has settled on a trading strategy that works for them—be it day trading or swing trading—they might feel a little too confident about the potential profits that their actions might fetch. Analyzing risks and managing them can help traders stay grounded and accept the reality that they can’t win on all trades.
Risk management tools are meant to supplement (and not supplant) the larger strategy a trader is using. They are meant to help them maximize profits and reduce loss margins.
Types of risk
Risks are factors that lead to failure, so assessing them in time takes you halfway to success. But first, you will need to have a sense of the different kinds of risks out there.
1. Credit risk
Credit risks emerge when the actors behind a crypto project fail to fulfill their obligations. They are usually triggered by financial or ownership difficulties. They can create a loss of confidence or even totally wipe off a crypto’s value.
2. Legal risk
Across the globe, governments adopt a variety of regulative stances on cryptocurrencies. When governments ban crypto or mining, it directly affects traders. Because when such things happen, holders sometimes choose to dump their holdings at lower prices, leading to huge losses. The risks associated with such government- or law-related moves are called legal risks.
One example of legal risk in crypto trading is China’s ban on crypto mining and transactions. The decision sent ripples through the crypto world, leading to a temporary decline in value that hurt traders.
3. Liquidity risk
Liquidity risk refers to the situation when it becomes hard for crypto traders to convert their crypto earnings into fiat currency. This risk emerges when financial institutions place restrictions on the ability of traders to convert their positions to fiat currencies. When the trader has to accept poor conversion rates, they might run losses on their gains.
4. Market risk
Risks are situations when the value of crypto changes because of certain developments beyond the trader’s control. Market risks are damaging since drops in market prices lead to subsequent losses in earnings for the crypto trader. When market risks emerge, crypto coins might move up or even down, contrary to the trader’s projections during the opening position.
Strategies to manage risks
In crypto trading, a good rule of thumb is “Don’t risk more than you can afford to lose.” But there are some specific strategies as well that traders can employ to manage risks.
Stop loss + Take profit
When a trade doesn’t pan out the way the trader hoped, they need to act fast to avoid further losses. “Stop Loss” is an executable order placed with a broker of some kind to designate the price or point at which the trader will sell their crypto before the market turns against them. As a tool for risk management, Stop Loss help traders calculate the maximum loss they should accept in a trade when price movements are unfavorable. The Stop Loss strategy is effective since it allows traders to avoid the “things might get better” mentality when crypto suffers from volatility.
On the other hand, Take Profit is an executable order placed with a broker that sets the price when a trader should sell stock to gain profit. In crypto markets, bull runs—when prices rise steadily—are common, but when they happen, they are usually followed by dips. Take Profit is a useful strategy in such markets because when prices change favorably, the trader can cash in before the period of consolidation happens.
Traders can take advantage of the capabilities of trading platforms that allow them to set Stop Loss or Take Profit points to cover them from sudden market shifts.
Sometimes, a crypto trader can choose to manage risks by looking at the risks involved in a trading decision alongside the potential reward. The risk/reward ratio considers the actual levels of risk while allowing the trader to know the potential returns. In crypto trading, the higher the risk of a market position, the more profitable the rewards.
To calculate the risk/reward ratio, one must evaluate the total potential profit (target price – entry price) against the total potential loss (entry price – stop loss), as elaborated in the formula below.
Risk ratio = (Target Price – Entry Price) / (Entry Price – Stop Loss)
If the risk ratio is 1:1, your profit or loss potential is higher than 50%. Seasoned traders prefer a risk ratio that is 1:2 or 1:3 since their profits are double or triple the expected risks. Using the risk/reward ratio helps minimize losses while increasing earning potential.
Ever heard the saying that you should never put all your eggs in one basket? Position sizing indicates the volume of a trade or transaction. In crypto trading, traders realize that some cryptos have higher risk and profit potential than others. Understanding that helps traders to invest a particular sum in trade to ensure protection against risks during price movements.
Three approaches that traders can use to achieve position sizing include:
1. Enter amount vs. risk amount
This position sizing approach compares the amount you wish to invest to the amount you would lose if trading fails. The sum of your trade should be calculated as follows.
Position Size = [(Stack Size * Risk Per Trade) / (Entry Price – Stop Loss)] * Entry Price
2. Elder’s “sharks” and “piranhas”
This method of positioning sizing emphasizes diversification. Looking at every risk as a shark bite, you should limit your position to 2% risk. This way, you could avoid huge shark bites (major losses).
The “piranha” describes that trading should be limited to 6% per session. So, if there is a losing streak, little by little, the piranha-bites (minor losses) are tolerable at all times and can help you reevaluate your position during the next session.
3. Kelly criterion
The Kelly criterion is a tactic that favors long-term trading by defining the percentage of capital to bet. It is calculated by using the following formula.
A = (Success % / Loss Ratio at Stop Loss) – [(1 – success %) / Profit Ratio at Take Profit)]
A crypto trader should ideally choose the position sizing strategy most suited to their personal trading strategy. Whichever choice you make, pay attention to the risk values and always know that smaller but sustainable profits are preferable to high risks that lead to losses.
Crypto values are constantly changing, so patience and extreme risk management are crucial to survival and success.