Just like any other trading market and product, cryptocurrency trading is not exempted from the possibility of a loss. Risk management is used to maximize profits and minimize losses as much as possible.
What is Risk Management in Trading?
Trading in stocks, forex, or commodities is always subject to market risks. Therefore, every investor must learn how to calculate the possibility of losses and create strategies to avoid them. This method can increase the profit potential and protect the investors from the probability of sustaining losses. This process is known as risk management.
Types of Risk Management Terminologies
Here are some popular risk management terms used by professional investors:
Risk per Trade
This metric is used to calculate the risk appetite or the ability of an investor to sustain risks based on their trading experience, total investment capital, and percentage of investment in a particular investment asset.
The total amount or volume of a trading position for a given asset is indicated and calculated by position sizing. It is also used to determine the frequency of a trading position in the case of leverage trading. It can be used to determine the ratio of profit or loss probability as well.
Initial Risk Level
It is usually calculated based on the initial stop-loss such as the support level if a new position is created near it.
This is used for a moving stop-loss order or to determine several points for a stop-loss progression based on the study of market indicators such as moving averages and average true range (ATR).
This area is highlighted by analysts as the most potent price position where a majority of investors are likely to take profits.
The risk-reward ratio is the correlation between trading risks and the potential of reward. It means that it represents both profit probability and chances of losses at the same time.
What is Risk Management in Crypto Trading?
Cryptocurrency investors can purchase digital assets from centralized exchanges and OTC platforms. Here are some of the most common risk management techniques:
There are always concerns about new regulatory laws for cryptocurrency entities. At present, most governments do not have any proper crypto regulatory clarity. Therefore, some commercial enterprises are hesitant to invest in digital assets due to the possibility of unfavorable crypto regulations.
Cyber-attacks and Technical Failures
Cryptocurrencies and DeFi entities are always vulnerable to cyber-attacks. Therefore, it is best to check for technical audits before investing in a new cryptocurrency project. At the same time, there is a slight chance of technical lags that lead to exploits and other issues for blockchains.
Cryptocurrencies are stored in digital wallets. However, many people store their digital currencies in non-custodial wallets present on crypto exchanges. It means that the person buying the crypto does not own them. Many investors opt to transfer their custodial wallets, hardware wallets, or paper wallets.
Cryptocurrency exchanges are both regulated and unregulated but they carry the following risks:
- Sudden delisting of a cryptocurrency.
- The outage of crypto exchanges due to technical, scalability, high trading volume, or unusually high volatility sector.
- Price manipulation.
- Stop-loss targeting.
- Connectivity problems.
Leverage is conducting trades with borrowed funds or cryptocurrencies to increase the overall profit percentage. Here are some common leveraging risks:
- Unexpected trend reversal.
- Interest inflation on leveraged position.
- Lapse of collateral value due to price changes.
Liquidity is the ability to convert positions into cash or cryptocurrencies without big slippage generation. If an asset has low liquidity, the investors will be unable to easily exit their positions at their targeted market value. Offset liquidity risks are as follows:
- Invest in cryptocurrencies with high trading volume.
- Trade during business hours.
- Pick tight spreads because they ensure higher liquidity.
Popular Risk Management Strategies
Multiple Time Frames
When analyzing the price movement of a given cryptocurrency switches between multiple time frames. This will help the investors to get a clear big picture and also explore small market movements in great detail.
It is best to work out the best position size for a new trading position. Investors should calculate it based on their total investment capital, risk appetite, risk-reward ratio, and stop-loss.
It is possible to generate profits when an asset is losing price by shorting method. A short-squeeze happens when investors are shorting but the price continues to rise and shorters have to purchase more assets to offset their losses. This can increase the price of a cryptocurrency exponentially. It is a possible risk for short traders but a great chance for bulls.
Stop-loss is created to exit a trading position automatically once the predetermined price is reached.
Learn Market Analysis
Learning about fundamental and technical analysis is a great way to understand market dynamics. It also helps traders implement risk management techniques more effectively and devise winning trading strategies.
Investors often try to disperse their investment across various cryptocurrencies and other assets to avoid getting REKT when one market goes into bearish mode. Investors also use the 2% and 6% rule. It means investing at most 2% of your total capital in one particular asset and stopping investing in that asset if you have lost 6% of your trading asset.
Risk management is an essential part of cryptocurrency trading. Without learning about risk management and implementing it, it is impossible to succeed in the crypto markets.