Understanding the Importance of Risk Management in Crypto Trading
First and foremost, we have to establish that the crypto industry offers an incredible variety of financial instruments to choose from. However, any investor interested in allocating their money in this industry must remember that all these assets are inherently speculative as buyers do not acquire any physical goods, products, or infrastructure like they do when they purchase stocks.
Crypto trading is almost always a speculative process that completely disregards many approaches commonly used by the proponents of fundamental analysis. The issue here is that crypto assets cannot be evaluated like a stock or a government bond.
Let’s take a look at what metrics are usually looked at by fundamental analysis experts:
- The amount of revenue generated by a company or gross domestic products numbers for government bonds. These metrics and those associated with them show the performance of an economic entity and its capacity to generate the same numbers in the future. When compared with other similar companies and governments, it produces a good idea about whether it is overvalued or undervalued.
- The value of real assets owned by an entity. For example, some companies may have multiple real estate properties, some infrastructure, heavy equipment, vehicles, and more. These are often overlooked by potential investors who do not appreciate the value that can be generated by either properly managing these real assets or simply selling them during a company liquidation process.
- Human capital and brand value. Specialists and the size of teams involved in producing goods or providing services from a company that you try to evaluate. These are often hard to evaluate but still give you meaningful insights into the inner workings of a company and how it compares against peers. Brand value is also a huge metric that can be evaluated with the help from experts in this field.
While the latter somewhat applies to many crypto assets, they are still just a piece of code that investors put their trust and hope in. If the Bitcoin ecosystem collapses, you won’t have anything left: no cars, houses, or products to sell. What it means is that any cryptocurrency is essentially speculative and relies solely on the level of trust it generates within the global financial community.
In such markets, technical analysis is the only applicable approach to evaluate financial assets. Some fundamental approaches are also valid, but pale in comparison with what a good technical analyst can extract from a single price chart. Since you have to rely on sophisticated technical analysis strategies, risk mitigation techniques become crucial.
The importance of risk management system in trading is hard to overestimate. You need to employ multiple methods of reducing risks to counter the strong uncertainty often accompanying various tokens that are developed by unknown specialists and offering no minimal viable product until some distant date in the future.
We will discuss different risk management strategies that contemporary crypto retail traders can use to reduce the exposure of their portfolios to various dangers of the most novel financial market in the world.
Set Clear Risk Tolerance and Define Your Investment Goals
Let’s start from the basics. Risk tolerance is essentially an amount of capital you are willing to lose if something goes wrong with your investments. The higher the number, the bolder moves you may make in the crypto industry.
Here are some really simple examples of how your risk tolerance or style affect the decisions that you make:
- If you are willing to lose 10% of your portfolio on a risky bet on an up and coming DeFi platform that has a 50/50 chance of making it, many will consider it a moderate risk style.
- If you are willing to lose 50% of your portfolio on the same investment, the vast majority of experts will say that you have high risk tolerance and use a very dangerous approach to investing.
- If you are willing to lose a 100% of your portfolio, most reasonable people will call your reckless or unable to cut losses when it is a necessity rather than a reasonable decision.
Some conservative retail traders set their risk tolerance level at 5% or lower. It is a very ineffective way to protect your market positions since 5% is often lower than standard market deviation in some assets meaning that even a simple price retracement will force you to liquidate a potentially profitable order. Finding the right balance between the level of risk you are willing to take on and investment goals is a hugely important skill that every must learn.
To identify the right equilibrium that will bring your to prosperity, you need to focus on setting investment objectives that can be realistically achieved without dwelling into the territory of uncomfortably high risk tolerance. Investment strategies executed without appropriately evaluated profitability targets will be chaotic and unfocused.
Here are some general rules that many experts usually tell newcomers:
- Try to limit your losses to roughly 10% — 20% of your total portfolio size on any market position. If your losses start exceeding set limits, it is a good idea to cut them and move on to the next investment opportunity. Otherwise, you may fall into the never ending spiral of the sunken cost fallacy and eventually lose everything.
- The risk level that you are willing to take must correlate with the size of a potential reward. For something with about 2% return on investment, risking more than 1% is unreasonable. However, when you are putting money into a token that may return 10% or more, it is a good idea to raise the risk tolerance level to at least 5% — 7%.
- It is a good idea to protect your market positions with various hedging tools. For example, if you are placing a BUY order for Bitcoin, consider using a leveraged short position to mitigate potential risks in the short term if you see that a temporary bearish movement is taking form in the market. Usually, you will need just a fraction of your long position for collateral on your short position placed with your margin trading account.
- Do not tunnel vision on a single asset class when managing risks. It is always a good idea to spread the risk across multiple different assets that have varying risk profiles. Put some of your money into safer assets like real estate, precious metals, and some commodity futures alongside your long positions on riskier assets like Bitcoin and startup stocks.
Diversify Your Crypto Portfolio to Minimize Risks
Diversification is an important skill that must be mastered by anyone who wants to conquer the world of finance. While many people believe that it is a good idea to put all your eggs in one basket (i.e. “hodlers” and some venture capitalists), the vast majority of successful investment managers usually try to invest in several wildly different asset classes even when their risk profiles look similar.
There are different diversification techniques that can be used to build a balanced portfolio:
- Focusing on multiple assets within a single asset class. Even hodlers recognize that there are other tokens in the market besides Bitcoin. Ethereum and Cardano are two proof-of-stake validation mechanisms that have a strong potential to become the backbone of the crypto industry going forward. While $ETH and $ADA often correlate with Bitcoin, they may move in the opposite direction when something changes in the blockchain industry. Spreading risks in crypto trading across multiple different tokens is a good idea.
- Focusing on acquiring different classes of assets. The current landscape of the crypto industry features endless opportunities for diversification, but all tokens are speculative meaning that if the whole industry goes bust, every token loses its value instantly. Looking at other assets backed by real investments and physical infrastructure can be a much better idea. Buy some stocks (preferably, blue chips) and real estate to protect your portfolio from general risks associated with the whole crypto industry.
- Using assets with fixed income and equity investments. Fixed income assets are investments that offer stable returns. These are represented by government and corporate bonds in TradFi and staking in DeFi. Most investors prefer mixing together fixed income assets and some equity investments (stocks and some tokens are considered equity) to reach a certain investment goal without risking everything. Strangely enough, the best-performing funds have been strongly focused on using only equity investments without relying on bonds for portfolio protection.
Crypto portfolio diversification can be quite complex since you don’t really have intuitively safe and risky investments like in the case with conventional financial markets where most investors know that buying real estate or government bonds is a generally safe investment. Choosing the right tokens and staking pools to build a balanced crypto portfolio is a very challenging task.
Implement stop loss orders and take profit levels
Delayed orders are used by manual traders and people who run automated trading systems even more so. These orders are executed after you create a new market position under certain circumstances. Most commonly used orders are Stop Loss and Take Profit. The former is triggered when the price of a target asset dives down to a set minimum price. The latter is triggered when a certain level of profitability if reached.
These orders must be used for each of your market positions regardless of whether you risk management trade only manually or run a massive bot operation.
Here are some tips that you can use for managing potential losses and gains in crypto trading by using delayed orders:
- Long-term market positions put a strain on your portfolio due to locking your assets for months and, potentially, years. It is a good idea to have them if you expect significant returns and can sustain some dips in your portfolio as long as the end goal is reached. Use the 1:3 ratio for such positions. 1 to 3 means that you set your stop loss at 1 third of your investment goal. If you expect to gain 30% on your investment, have a stop loss order for about 10%.
- Mid-term market positions must generate significant results and outpace fixed-income assets in terms of profitability. When government bonds with fixed yields offer 5%, your mid-term assets must generate more plus premium for the risk. While many experts define and calculate risk premiums differently, the general rule of thumb is to set it at roughly 2%. Mid-term market positions that are positioned to earn 10% — 20% must be protected by 5% — 10% stop loss orders. The 1:2 ratio is frequently used for such market positions.
- The 1:1 ratio is used by day traders and scalpers. It is possible to have the same ratio for long-term positions, but they defeat the purpose of holding assets for years as you reduce the efficiency of your investments without aiming at higher profits. Scalpers have to make money and protect themselves from unexpected volatility. Mathematically, you will need to predict at least 70% of all your trades correctly when using the same order size with 1:1 SL/TP ratio.
Stay Informed and Conduct Thorough Research Before Investing
Two main skills discussed above are technical approaches to the art of risk management, but you should also use some crucially important skills that meaningfully complement the tools used to reduce risks that endanger your portfolio. One thing that many investors tend to underestimate is the importance of research.
The crypto community has a motto “DYOR”. It is an abbreviation standing for “Do Your Own Research”. As many people became victims of different scam-projects and pump&dump schemes, the motto gained popularity among more reasonable people who were actually interested in researching various DeFi platforms before blindly investing everything they had based on just hype.
Researching blockchain networks, their products, and potential can be extremely challenging considering the sheer complexity of the crypto industry and the number of interconnected platforms that create a multidimensional ecosystem where each component can play a huge role in the success of another. The unfortunate thing here is that these connections may turn out absolutely irrelevant or fail to materialize into something valuable.
We know that the speculative nature of many assets in the crypto industry means that people cannot really use traditional evaluation methods that are employed by people engaging in fundamental analysis. You cannot pull data from a verified source to check revenues, EBIDTA, outstanding loans, and other important metrics to understand the real situation in a DeFi platform.
Nevertheless, some tips for conducting due diligence before investing can be extremely useful:
- Do not believe the hype or, at least, be considerate when reading hopeful comments of aspiring investors and industry experts. Many DeFi platforms have been propped up to be the next Bitcoin, but 99% of them failed miserably and never lived up to the hype. There are numerous examples of some tokens making it big, so investing in them is not a bad idea, but it must be backed up by thorough independent evaluation free of biases conceived by reading opinions of retail traders who are already invested in a project.
- Use a variety of sources to verify evaluations. It is easy to get into a warm and cozy bubble of ideas bouncing from one Discord member to another. However, the cultish behavior of the crowd often creates a pool of information that deceives newcomers and pulls them in while cutting off any other sources of useful information. Make sure to talk with people who are critical of the project and take every bit of news and promises from developers with a grain of salt.
- Read more about people behind every project. There have been some success stories in the industry when it was taking shape back in the 2010s, but the contemporary landscape of the blockchain ecosystem is mature enough to have talent that can build new platforms. If you do not see credible developers and experts behind a new up and coming DeFi project, it often means that it won’t be warmly accepted by investors and the community.
- Staying updated with market trends. Regularly expecting the market as a whole and the situation surrounding your target assets is something that you should do at all times. Using technical analysis strategies to evaluate the future prospect of a target asset while comparing its performance with correlated or similar assets can be a valuable source of insights. Technical analysis is not a panacea for all your risk management woes, but it is an often overlooked approach to evaluating cryptocurrencies.
Use Risk Management Tools and Calculators to Assess Potential Losses
The modern crypto industry is a complex ecosystem that allows many businesses to flourish. A typical retail trader usually uses a very limited range of instruments despite having access to an incredibly rich assortment of risk management tools for crypto traders designed to help them mitigate losses and reach consistency.
The variety in the industry of financial products aimed at retail traders is quite astonishing. We won’t try to cover all useful tools. Instead, let’s talk about a couple of interesting solutions that help traders achieve profitability:
- Risk calculators for assessing potential losses are tools also known as crypto position size calculators. These instruments help retail traders predict potential losses or profits based on their estimated risk tolerance, target assets, trading fees, and other factors that affect the outcome. While calculators should never be considered sources of viable investment advice, they can be handy when you are trying to assess whether you want to engage in a trade.
- Portfolio management kits. Many products by highly specialized technological companies in the crypto industry are focused on providing detailed breakdowns of portfolios. For example, people interested in automation and its various forms may use special tools offered by the WunderTrading platform where you can track the performance of each bot in real time.
- Analytics services from established providers like Nitrogen. Many financial advisors offer unique services in risk assessment and portfolio analysis. If you have a large portfolio that includes multiple various assets, it is a good idea to work with experienced professionals to bring some expertise to your investment efforts. Risk management for traders can be an overwhelming task in some cases.
Consider Utilizing Hedging Strategies for Added Protection
Some retail traders do not like the idea of using hedging mechanisms because they can reduce the efficiency of your portfolio in the short term. It is true that sometimes placing a hedging order to protect your long positions feels unnecessary, but it must become a habit. Otherwise, you will inevitably encounter some devastating situations where your portfolio will be compromised due to the lack of any hedging market positions.
Many believe that crypto hedging strategies always involve shorting certain types of assets, but there are many interesting techniques that allow retail traders to hedge against specific risks without exposing them to the dangers of leveraged positions.
- Hold antagonistic assets in an overall bullish market. Many tokens have intricate relationships. For example, Bitcoin competes against Ethereum and other PoS tokens directly as these two approaches to validation have very different goals and underlying technologies. It means that holding both $ETH and $BTC is a good idea when the whole market is bullish. These two assets will likely go up together, but if $BTC will start going up, $ETH will pick up the pace.
- To exercise risk management, trade with novel strategies and instruments. Just holding $BTC and other mainstream tokens can be a valid strategy, but you should also run something conservative alongside your long positions to ensure that you are protecting the portfolio against market volatility with hedging techniques like statistical arbitrage or automated spread trading. These are generally safe approaches and can be a good way of defending long positions.
- Use contemporary approaches to old school methods. A DCA bot strategy is a good example of a conventional method to acquiring assets executed by a novel automated trading system that can help you build a portfolio over time while reducing the cost of investments. Distributed cost average is a time-tested way of buying assets at a lower cost than the market’s average by splitting any purchase into a series of trades. You can fully automate the process and reduce some risks by saving money on each purchase.
It is hard to create an appropriately balanced risk management in trading crypto, but many successful retail traders are capable of achieving consistency and long-term success by simply utilizing standard risk reduction approaches that have been around for centuries. DCA was conceived in the 1920s and arbitrage rules were identified and practiced since at least 2000 BC.
Without a good grasp on how to manage risk in trading, you will quickly succumb to market volatility and economic uncertainty which are two main issues in the crypto market.
Controlling risks with automated trading systems
Contemporary retail traders rely on automation to design consistent trading systems. These can be much better since you automatically protect each of your market positions with delayed orders placed immediately after the placement of an initial order or simultaneously. Smart bot users always use risk management tools embedded in automation systems.
Here are some ways you can reduce risks by using automation:
- If you have a portfolio that lean toward a higher risk tolerance level, you may want to choose time-tested preset automation solutions such as GRID bots or arbitrage bots. These approaches are conservative and can be easily protected by stop losses to generate profits consistently. Usually, you cannot expect massive profits from arbitrage, but they are quite reliable and can be a good hedge against your long positions exposed to uncertainty and additional risk.
- Use strict stop loss and take profit rules. Since you mostly rely on technical analysis when trading, it makes sense to automate every single trade triggered by a signal from your indicators. Manual order placement can be quite slow and chaotic, especially for day traders. People often forget to set up proper SL/TP orders and suffer great losses. Automated systems can be set to use very specific SL/TP ratios when they place any order.
- Immediate shorting. This approach is an interesting way to protecting your long positions with automatically placed short-selling orders during temporary price retracements in a bullish market. It is natural for the market to correct itself as the price tries to stabilize at a new support level. As bulls push the price up, it may retrace significantly under the pressure from bears. An automated system can sell assets whenever a short-term price retracement takes place.
These are just simple examples of how you can use automation to hedge against any risk. Creative retail traders use sophisticated strategies to create hedging market positions while they focus on acquiring specific assets or amassing a large Bitcoin portfolio.
Prioritize Risk Management to Safeguard Your Capital in Crypto Trading
The most unfortunate thing about the crypto industry and its public image is that many early adopters were not educated or experienced enough to make smart investment decisions or quickly identify projects that are destined to fall. They were replaced by a new wave of people who only wanted to make a quick buck and often hyped up obvious pump&dump schemes.
Only a couple of years ago, the industry started stabilizing and cleaning up messes that were left behind by chaotic novices and scammers with bad intentions. However, the industry was heavily affected by the last echo of the times when irresponsibility ruled the market as FTX collapsed and caused massive damage to all financial institutions in the industry. Then, a lengthy crypto winter crippled many tokens and caused strong bear movements across the board.
Times have changed. We have an army of seasoned investors and large financial institutions interested in a more regulated and stable environment. In this new ecosystem, people who use advanced techniques of risk management for trading endeavors usually enjoy much better chances of succeeding.
We strongly believe that every individual investor must use as many risk management tricks as they can. It will benefit them and the whole industry as more people will avoid bad projects and pour their money into DeFi platforms and blockchain networks that can grow and be successful in the long run.
Use various hedging techniques and exercise in short-selling to maximize the efficiency of your crypto investments. Our lengthy guide provides a plethora of interesting approaches to protecting a portfolio, but we only grazed the grass on each topic. Research them more to use them as well as humanly possible to avoid undesired financial losses.