Risk Management in Cryptocurrency Trading
Longstanding risk management strategies can be applied to enhancing your trading skills, minimizing risks, and maximizing profits in the volatile cryptocurrency market.
Key Takeaways:
- Effective risk management for cryptocurrency trading requires you to take steps to minimize losses and maximize profits
- It involves accounting for price volatility and other market risks
- Key strategies involve diversification, risk-reward ratio monitoring, position sizing, stop orders, and other strategies and tools
- Advanced crypto investors may consider using hedging and derivatives
Introduction
Cryptocurrency trading is rapidly gaining popularity among the general public and traditional investors.
However, cryptocurrency investment comes with volatility risks. Like stocks and other traditional assets, crypto prices change multiple times per second. Furthermore, the cryptocurrency market operates 24/7 without closing, meaning that prices change around the clock.
Other factors also impact prices, including price discovery, market liquidity, asset issuance models, and the overall size of the crypto market — making crypto prices especially volatile.
It’s important for crypto traders to engage in risk management in light of the above challenges. The right risk management strategy will help you maximize profits and minimize losses.
Understanding Risk Management
Risk management is the process of identifying and accounting for potential trading losses, which in turn will allow you to maximize your profits.
The first step toward creating a risk management strategy involves analysis of risks.
Top Risks in Crypto Trading
There are several risks that crypto inventors should be aware of, including:
- Market risk: This term typically refers to the volatility of the overall crypto market; it is also known as systematic risk
- Specific risk: This term describes risks impacting a specific asset or area of the market; it is also known as unsystematic risk
- Liquidity risk: Liquidity risk occurs when there are too many buyers or too few sellers for an asset, which can prevent you from trading at the right price — or at all
- Market manipulation: Coordinated large-scale trading such as pump-and-dumps and wash trading can artificially influence trading data, making it difficult for investors to decide whether an investment is truly worthwhile
- Regulatory risk: Insufficient or unclear regulations can provide you with little investor protection, leave you with unclear tax obligations, or expose you to scams and fraud
- Leverage risk: Investors expose themselves to additional risk of loss if they engage in leveraged trading, a strategy that involves borrowing
- Security incidents: Some crypto projects are vulnerable to hacks and exploits, meaning that an otherwise strong crypto token may lose value following an incident
- Emotional trading: Fear of missing out (FOMO), panic selling, and aggressive overtrading can all impact your profits and losses
In short, failure to monitor markets, failure to prepare for unexpected incidents, and impulsive trading decisions cover many of the risks that investors are exposed to.
Key Strategies for Effective Risk Management
You can obtain some degree of protection simply by accounting for each risk. However, there are several strategies that enable more effective risk management.
We’ll look at several strategies below.
Diversification
Portfolio diversification involves investing in several cryptocurrencies rather than just one.
Bitcoin (BTC) is the oldest and best-known cryptocurrency. It dominates the crypto market with a market cap of $1.3 trillion as of June 2024. However, there are many other popular cryptocurrencies, such as Ethereum (ETH), the second largest cryptocurrency by market cap.
If you invest solely in BTC, you can diversify your portfolio with ETH. By doing so, you might limit your losses if BTC prices drop — assuming ETH does not fall alongside BTC.
The benefits of diversification may be limited. Bitcoin is highly correlated with ETH and the rest of the crypto market, potentially limiting the benefits of this strategy.
Some lesser-known alternative cryptos or “altcoins” are less correlated with the rest of the market. Unfortunately, they may be even more vulnerable to loss than Bitcoin, meaning that choosing the wrong asset can add additional risk to your portfolio.
Ultimately, it’s best to diversify between recognized, established, and somewhat stable cryptocurrencies despite the limitations of that strategy.
Position Sizing
Position sizing involves determining the amount of capital that you put into a trade. Naturally, using a smaller amount of capital will limit losses.
Investopedia suggests putting no more than 2% of one’s capital into any trade. However, investors with a high tolerance or appetite for risk may use more capital. Position sizing is ultimately a guideline for investors who want to limit their losses.
Risk-Reward Ratios
Risk-reward ratios represent the potential reward that an investor can earn on every dollar invested. In other words, lower risk-reward ratios represent lesser risk for the same gains.
Calculating risk-reward ratios can be complex. Investopedia explains how to calculate based on various factors, such as projections of historical returns, weighted probabilities of future outcomes, and the capital asset pricing model (CAPM).
However, representing risk reward ratios is simple. A ratio of 1:5 means that an investor risks $1 dollar to earn $5, whereas a ratio of 1:3 means an investor risks $1 dollar to earn $3.
A risk reward ratio of approximately 1:3 is generally considered low-risk.
Utilizing Technical Analysis
Technical analysis involves examining price data, charts, patterns, and indicators to predict price movement and calculate risks and rewards.
While critics argue that technical analysis is not a fine science, many patterns used in technical analysis are widely observed. Trendlines, continuation patterns, reversals, flags, triangles, and other patterns can help you predict price movements, as explained by Investopedia here.
Continuous Learning and Research
Crypto markets rapidly change. Important events and developments can affect existing cryptocurrency prices, and new assets can originate and shake up the market.
It’s important to stay informed about market trends and news. Useful resources include:
- Market aggregators like CoinGecko and CoinMarketCap
- Market-focused sites like Seeking Alpha
- Leading crypto news sites like CoinDesk and Cointelegraph
- Multi-site news feeds like CryptoPanic
- Insights from crypto firms like Coinbase Research
Setting Stop-Loss Orders
Stop loss orders allow investors to automatically execute a trade upon certain events — typically by selling an asset when its price drops to a certain value.
The most effective rates depend on whether you are actively trading versus investing long term.
For example, short-term investors may choose a 5% limit and sell even after minor fluctuations, while long-term holders may set a 20% limit and sell only after major price drops.
Regardless of the optimal limit, stop loss orders are an effective way of dealing with the fact that crypto prices change rapidly and around the clock.
Leveraging Risk Management Tools
Crypto exchanges and trading platforms offer numerous other risk management tools. Trailing stop orders, for example, are specialized stop orders that move in one direction in order to lock profits or limit losses, providing more flexibility than their basic counterpart.
Take profit orders, meanwhile, automatically sell some or all of your investment when a crypto reaches a certain price, ensuring that you earn a profit when it is possible to do so.
Typically, you’ll need to access these features through your crypto exchange’s advanced interface or order book interface. Note that some exchanges may not offer all features.
Emotional Control and Discipline
No trader is free from emotions when they make a decision, and there are many aspects of the cryptocurrency market that can influence one’s state of mind.
Be aware of promotional techniques in the crypto sector that attempt to play on emotions, such as fear, uncertainty, and doubt (FUD), fear of missing out (FOMO), and hype. You should thoroughly research every project and token before investing.
Also be aware of your own undesirable tendencies and those of other investors — such as panic selling, greed, and aggressive trading strategies.
However, an overly cautious approach can also result in failure to act. This can cause losses just like an aggressive approach. A clear-minded and balanced approach is key.
Advanced Risk Management Techniques
Hedging
Hedging strategies allow investors to limit risk by taking a position in an opposing asset.
Sometimes, hedging involves purchasing an asset that is inversely correlated with one’s original investment. A perfect hedge is 100% inversely correlated with the original asset.
It is not always possible to find cryptocurrencies that have inversely correlated performance.
However, there are other methods for hedging, such as derivatives trading.
Using Derivatives for Risk Management
Derivatives — alternative investments that are dependent on the value of a particular cryptocurrency or multiple cryptocurrencies — provide one approach to hedging.
There are numerous derivatives products available. For example:
- Futures contracts allow you to buy/sell an asset at a set price on a certain future date
- Options contracts give you the right, but not the obligation, to buy or sell an asset before the contract’s expiration date
- Contracts for Difference (CFDs) are contracts in which you agree to exchange the difference in an asset’s value between an opening and closing price
- Perpetual swap contracts are similar to futures contracts but do not have a set expiration date and can be held indefinitely
Accessing Crypto Derivatives
Your usual crypto trading platform may not offer crypto derivatives. It may also limit crypto derivative trading to specific regions or a separate, dedicated platform.
Still, some derivative platforms exist. The major crypto exchange Coinbase offers crypto derivatives to non-US investors and plans to extend this to US users in the future. Market aggregator CoinGecko lists a variety of other derivatives markets available to users.
Services in the UK are limited, as the country banned most crypto derivative trading in 2020.
Investing in ETFs
Exchange-traded funds (ETFs) are not derivatives in their own right. However, you can gain exposure to derivatives by investing in ETFs.
For example:
- Bitcoin futures ETFs invest in Bitcoin futures, a type of derivative
- Inverse Bitcoin ETFs are not derivatives but typically make use of derivatives to provide returns when a fund declines
You can usually invest in crypto ETFs through traditional brokers rather than crypto exchanges. Once again, availability of these funds depends on your location.
Conclusion
Risk management is a key part of crypto trading, as it is in any other form of investment.
Engaging in the strategies outlined in this article will help you minimize losses, maximize profits, and account for otherwise unpredictable events and market movements.
In addition to simply being aware of risks, you can pursue various basic and advanced strategies to limit your risk. You can use techniques such as diversification and position sizing to minimize losses.You can also use hedging and derivatives to take out an inverse position.
Risk is not fully avoidable and profits are not guaranteed in crypto investing. However, the right strategies will help you make the most of your investment portfolio.
Additional Resources
Several leading crypto exchanges and other companies have published guides on crypto risk management. Check out these guides:
- ByBit's “Crypto Trading Risk Management: How to Mitigate Risk Exposure”
- Bitrates’ “What Are the Risks of Investing in Cryptocurrency?”
- Kucoin's “Mastering Risk Management in Crypto Trading”
- Fidelity’s “Tips for managing risk in crypto investments”
- Gemini and Cryptopedia’s “Cryptocurrency Brings New Meaning to Managing Risk”
- Arkham Intel’s “Risks in Crypto Trading”
For audio-visual guides, consider these resources:
- Cryptohopper podcast episode “Discussing Crypto Investment Risk Management”
- Binance Australia’s “Crypto Trading Tools & Strategies - Risk Management”
- Smart Risk’s “Money and Risk Management Plan for Trading Forex Crypto & Stocks”
Finally, you can find full-length courses on investment risk management on Coursera and Udemy. These courses typically concern investments in general rather than cryptocurrency but will nevertheless help you learn more about risk management.
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