Remember the Dogecoin millionaire? In 2021, a man named Glauber reportedly invested $180,000 in Dogecoin. He took loans from his friend and maxed out his credit card to buy as much of the asset as possible. Soon, DOGE rose to fame, hit an all-time high, and made 1 million dollars. But, what goes up should come back down – exactly what happened to DOGE! Three years later, Dogecoin is still 90% lower than its all-time high. This is not an isolated incident but a stark reality in the crypto industry, which is why having risk management strategies in place is very crucial.
Whether you are an experienced trader or just throwing your hat in the ring, strategies for risk management in crypto trading can safeguard you. This article will help you understand why risk management is essential in crypto trading and the various strategies you can employ to navigate your way through crypto trading.
Why is Risk Management Crucial in Crypto Trading?
Crypto risk management is an important part of crypto trading where one can calculate the ratio of potential losses to the original profit potential based on every new position within the crypto market. This is often calculated through the risk-reward ratio. As one of the most volatile markets in the financial world, cryptocurrencies are susceptible to external factors. Whether it is regulatory restrictions or geopolitical shifts, price hikes and drops are very common in the market. Without proper risk management, traders can suffer huge losses in their trades.
Over-leveraging or avoiding stop-losses are some common trading mistakes seen in beginner-level traders. These losses can have negative financial consequences on traders and can lead to panic within the market. To manage trading risk in the crypto market, a risk management plan helps cultivate discipline, making sure traders can easily overcome rough trading situations.
Risk management is an important aspect of crypto trading, especially for a beginner in crypto trading. It helps minimize risks and potential losses, which is very common in a highly volatile market such as cryptocurrency.
Developing Your Risk Management Strategy
While seasoned traders know how to navigate the market, new traders often wonder how to manage risk in trading.
Define Your Risk Tolerance
To begin with a risk management strategy, traders should ask themselves what the risks of cryptocurrency are and accordingly define risk tolerance. Knowing the degree of risk, one can ensure that one does not overextend oneself financially. This also helps in preventing traders from losing themselves emotionally during a period of volatility in the market.
Risk tolerance can be assessed by various methods. Risk tolerance quizzes on the websites of financial institutions revolve around questions regarding a trader’s investment goal, reaction to potential losses, and time horizon. Risk tolerance quizzes assess a trader’s risk-taking appetite by creating hypothetical situations where the trader incurs losses. If a cryptocurrency that you invested in drops by 50%, what would your reaction be?
Depending on the answers, the quiz generates a score that can help analyze a trader’s risk appetite. The scores are often within three brackets: conservative, moderate, and aggressive, depending on a trader’s level of risk-taking bandwidth.
Set Realistic Goals:
Setting goals is an essential criterion of crypto trading, but more importantly, traders should set realistic goals. Trading does not provide quick profits in the short term, and many traders lose their money trying to chase the shortcut to success. That is why it is crucial to have realistic and achievable goals, in accordance with the trading strategy and risk tolerance for the trade, so that the trader can obtain profits. For example, a trader can be incentivized to achieve a 10% return over 12 months. However, trying to obtain extremely high returns on an investment without regard to the volatility in the market and/or impulsive trading can lead to significant loss.
Core Risk Management Techniques
Stop-Loss Orders:
Stop-loss orders are primarily utilized conditionally, where the order gets sold automatically once the asset crosses the specified price level. It is one of the most crucial settings for a trader since it stops a trader from maintaining a position that they cannot afford. It allows traders to safeguard their capital from large losses, which can occur instantly, particularly in a high-velocity market like crypto.
However, it is crucial to place stop-loss orders strategically. If a stop-loss order is placed close to the live market price or very far from the present market price, it can make traders lose money. Traders must carefully consider market dynamics and their risk appetite limits while setting the stop-loss levels. An optimal stop-loss can thus safeguard investments and keep traders afloat.
Take-Profit Orders:
A take-profit order can help secure the profits of traders by automatically selling an asset once the price of the asset reaches a prearranged profit level. Traders who wish to lock in their gains can utilize the take-profit tool to exit the market in a profitable position. By setting a take-profit order traders can make the most profit possible without having to keep an eye on the market movement. Like stop-loss orders, take-profit orders also need to be placed strategically – if placed too close to the current market price, they would limit the profits whereas if placed too far away traders can lose their potential profit if the market reverses. This is especially true for fast-moving markets like crypto.
Position Sizing:
Position sizing is an important risk management method in the crypto space. Position sizing helps determine how much capital exposure a trader should allocate to one trade regarding potential diversification opportunities within a portfolio. Position sizing provides strategies that traders can follow in gauging their risk parameters alongside their overall trading capital greed, allowing traders to position size their way to profit. The 1% rule is one such strategy in which traders are recommended not to risk more than 1% of their trading capital, thus promoting good trading practice. New traders can maintain a safe exposure and protect their trading money when following this rule until they learn the ropes of trading.
For the more advanced trader, the Kelly criterion is another dimension of position sizing. The Kelly criterion is a mathematical formula that can help the trader minimize their losses and maximize their potential profit. This crypto risk management system can provide various probabilities to determine the likely outcome of a trade and provide a solution on how much profit they may receive in return. Experienced traders can take their trading practice to a new level by incorporating this risk management system into their trading strategy.
Advanced Risk Management Techniques
Traders who have been in the crypto market for a while are quite aware of the volatility associated with it. This is why advanced risk management techniques can serve as essential tools to navigate the volatile crypto market. The go-to strategy for risk management is the diversification of assets. To reduce potential losses traders should not invest in one asset or tokens, diversifying portfolios can help traders reduce losses and balance their profits.
Crypto hedging is a great strategy to absolve losses. By taking an opposite position to the main investment, traders often invest in another cryptocurrency in the short-term, if the main crypto investment keeps tanking in the short period. Crypto hedging allows investors to reduce risks but does not eliminate it. For experienced traders, hedging strategies such as stablecoin lock-ins, short-selling, options trading, and futures contracts are a great way to market downturns.
Maintaining Discipline and Emotional Control
The crypto market is very volatile, and keeping feelings out of trading will be a key part of managing that risk. Traders need to minimalize factors such as fear or greed, as well as disciplined trades with periods of time off from trading. Journaling your trades can also help you make clear trading decisions without having to bank on your memory. These practices will ensure long-term success in crypto trading.
Conclusion
While crypto trading can provide investors with profits, without effective crypto risk management traders can incur detrimental losses. Using hedging tools can provide stability and reduce exposure to market volatility. However, traders should be able to refine their hedging strategies and keep up-to-date with the know-how of the crypto market to make sound decisions.
