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Crypto Risk Management

In this short and brief article, we will walk you through some actionable steps that should be taken into account while managing risk in the crypto trading.

 
Risk refers to the probability of the worst outcome an event that occurs against your expectations. Risk is a crucial aspect of crypto trading. It is the possibility of ill-favored outcome of the trade that will lead to losses. For instance, a 50% risk in a short position depicts the price of the cryptocurrency will go up in the upcoming future. Similarly, the possibility of potential loss in a trade is also the same.

In this short and brief article, I’ll walk you through some actionable steps that should be taken into account while managing risk in the crypto trading.

Types of Risk in Crypto Trading

Crypto trading subjects to the following risks.

Credit Risk

This risk is specifically hazardous for crypto projects. It is the probability that the development team behind a specific crypto project fails to comply with regulatory requirements that are envisaged crucial for the security of the digital asset. Credit risk leads to fraud, theft, and other malicious activities in the crypto market. A real-life example of credit risk in the recent past is the hacking of a Binance in 2018. Eventually, $40 million worth of the crypto coin was stolen.

Legal risk

Legal risk pertains to the probability of an unexpected event that may arise due to the legal constraints. For instance, a specific country imposes an embargo on cryptocurrency trading. A real-life example of legal risk is that when the states of Texas and North Carolina legally prohibit all the cryptocurrency exchanges in their country premises due to suspicion of being used in criminal activities like money laundering and terror financing. Similarly, in the recent past, some countries like India penalize those who were involved in crypto trading.

Liquidity risk

Liquidity risk means the owner of the crypto asset cannot use it for performing the day-to-day transaction. This is because cryptocurrency cannot be transformed into the traditional fiat currency which can be used to make purchases.

Market risk

Market risk is the probability that the price of crypto coins will appreciate or depreciate in the market against your expectation.

Operational risk

Operational risk often takes place when the crypto trader will not be able to trade, withdraw, or deposit money into their crypto wallet.

Effective Strategies for Risk Management

The most prominent rule of thumb for investment is “Do not take risk more than you afford to lose” with that being said, I strongly recommend all the crypto traders and investors to refrain from pouring more than 10% of their total budget or monthly earning into the crypto market.

The extreme volatility of the crypto market makes it more aversive to bullish investment. Additionally, borrow money for trading cryptocurrency will certainly dip your toe into the hefty loan.

Risk management strategies can be categorized into three ways:

  1. Position sizing
  2. Risk/reward ratio
  3. Stop loss and take profits

Let’s talk about each of those.

Position sizing

Position sizing briefly specifies how many crypto coins or tokens a trader is interested in buying. The probability of behemoth profits in the crypto market stimulates the trader to invest 30%, 50%, or even 100% of their total capital. Honestly speaking, this bullish investment strategy will take you towards the financial crisis.

The wisdom says never put your all egg in one beg but instead always attempt to smartly diversify your investment portfolio. Here are 3 highly practical ways to achieve position sizing.

Enter Amount Vs Risk Amount

This approach considers two different amounts. The first one is the amount in which you’ve decided to invest in crypto trading. I strongly recommend all the traders to pay close attention to this amount. The second one comprises of the money that is subject to risk i.e. that you are ready for the loss in case of failure.

You can leverage the following relation for speculating the amount you can invest:

A = ((Stack size * Risk per trade) / (Entry Price – Stop Loss)) * Entry Price

For instance, you want to buy BTC with the USD with a target of $13,000. In this scenario, our parameters are:

  • Stack size: $5,000
  • Risk per trade: 2%
  • Entry Price: $11,500
  • Stop Loss: $10,500

In this case, the ideal amount would be:

A = ((5000 * 0.02)/ (11,500 – 10,500)) * 11,500 = 1.150

The ideal amount to invest in this scenario is $1,150 or 23% of your total capital. However, due to our stop loss, we will restrict the risk to only 2%. Once the threshold amount is reached, the trade will be automatically stopped.

Elder’s “Sharks” and “Piranhas”

This part of portion sizing highly emphasize on the investment diversification. Dr. Alexander Elder, who coined this concept suggested two rules:

  • Limiting Every Position to 2% Risk: Our elder envisages risk as a shark bite. Sometime you would decide to take a huge risk, but the risk could be disastrous and lethal as shark bit.
  • Limiting Trading Session to Only 2%: In the case of successive losses, you may end up losing all your valuable assets categorically. Some peoples relate risk with the piranha attack that consumes its victim gradually.

By acting upon Alexander Elder’s rule, you’ll be able to significantly reduce the potential losses in the crypto market.

Kelly Criterion

Kelly Criterion is formulated by John Larry Kelly in 1956. It is the position-sizing approach that defines what proportion of your total capital should be invested. This approach is only feasible for long-term investing not for day trading.

You can calculate the ideal amount to invest with an aid of the following formula:

A = (Success % / Loss Ratio at Stop Loss) – ((1 – success %) / Profit Ratio at Take Profit)

Using the same assumption what we’ve taken before:

  • Stock size: $5,000
  • Invested Amount : $1,150
  • Success %: 60%
  • Entry Price: $11,500
  • Stop Loss: $10,500
  • Loss Ratio:1.10
  • Tax Profits: $13,000

The outcome would be:

A = (0.6/1.10) – ((1 – 0.06)/ 1.13) = 0.19

This value demonstrates you should not take risk of more than 19% of your total capital $5,000 if you want to obtain the best possible outcome from a series of trades.

Risk/Reward Ratio

The risk/reward ratio correlates the optimum level of risk with the potential return from the crypto market. Generally speaking, high risk skyrocket the potential of profitability. By thoroughly grasping the risk/reward ration you’ll be able to only enter a trade when the chances of profitability are maximum.

The risk/reward ratio can be calculated with an aid of the following relation:

R = (Target Price – Entry Price)/ (Entry Price – Stop Loss)

Using the numbers from the previous illustration:

  • Entry Price: $11,500
  • Stop Loss: $10,500
  • Target price:$13,000

Our outcome would be:

R = (13,000 – 11,000)/ (11,500 – 10,500) = 1.5 or 1:1.5

1:1.5 is a good option, but we strongly recommend trader to trade 1:1.5.

Stop Loss + Take Profit

Stop Loss is generally regarded as the executable order which ceases the open position automatically when the price of crypto-asset enhances up to a certain threshold. Apart from that, take profits is another example of an executable order when the crypto price appreciates to a certain level. Both of them are highly practical approaches for managing the risk.

Stop-loss mitigates the fear of losing money in the crypto market and take profits assists you to fell apart from the market before the market turned bearish. Unleashing the power of crypto terminals like Superorder, you can manage your Trailing Stop Losses and Take Profits in the real-time from the terminals.

Conclusion

When you enter practical life, you’ll come across many peoples who will teach you “find an appropriate job and then set aside a small portion of your total monthly earning for savings or investment” according to well-known business consultant Robert Kiyosaki “Put your money to work”

So you must have to invest some money to generate a passive stream of income for you. But in order to invest in any specific financial instrument like bonds, ETFs, equities, CFDs, cryptocurrencies, or commodities you must have to acquire extensive knowledge about risk management.

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