95% of all crypto newbies lose money, and the main reason for this is poor risk management skills and impulsive decisions.
Risk management should be the foremost thing on the mind of any smart crypto trader regardless of the trading experience. As much as trading crypto can guarantee your financial freedom when done successfully, it can also wreck you financially if you don’t tread carefully.
There's no reason to panic or be scared, like most things in life, you just have to be prepared with principles and strategies to guide you on your trading journey.
In crypto trading, effective risk management involves various steps taken to reduce the impact of a dip and to avoid total liquidation. The main step to take before trading crypto is conducting a comprehensive research that arms you with all the necessary information you need to making your trade a successful one.
In this article, we will discuss crypto trading risks, the importance of risk management, and effective risk management strategies you can implement in your trading so you don’t lose your trading capital.
Crypto Trading Risks
Cryptocurrency is growing rapidly, and the beginning of 2021 illustrates this beautifully. In February 2021, the total cap of the cryptocurrency market exceeded one and a half-trillion dollars. Just to compare, the market cap as of March 2020 was estimated at only 160 billion dollars.
As the market continues to grow, many people forget that cryptocurrency is not just about profits and anonymity, but also about risks. A crypto trader can face significant risks in the crypto market with the main one being volatility.
There aren't any financial asset type as volatile as cryptocurrency. The market can make a serious dip and rise in milliseconds. Different market sentiments can contribute to these kinds of unexpected movements in the market. It is not uncommon for the value of a cryptocurrency to drop by hundreds, if not thousands of dollars, in seconds, even. Since the government cannot interfere, there are very few avenues through which the government can introduce new laws, taxes, tariffs, subsidies, and trade restrictions to help cushion the effect of market failure.
Importance of Risk Management in Crypto Trading
- Prevent total ruin
The whole point of risk management is to minimize loss. I can’t tell you that you can completely prevent loss when you are trading crypto because that wouldn't be true. However, I can tell you that you can effectively manage losses once you have a risk management strategy in place. Think of risk management as a bulletproof vest worn by a soldier in war; it might not completely protect him/her, but it reduces the risk of fatal injuries.
Even expert traders with impressive track records of reading the market can lose it all in one or two bad trades if they fail to employ risk management strategies.
In a nutshell, risk management properly implemented can prevent total ruin in the case of a market failure.
Effective Risk Management Methods for trading crypto
Taking into account the different human psychology that causes us to take unreasonable risks, I've compiled a list of effective risk management methods that you can implement in your trades to minimize the effect of a market failure.
Diversify your trade
There is an old saying that you should never put all your eggs in one basket and it's no different in crypto trading. Diversifying your trade will considerably reduce the risk of total liquidation in the event of a market crash. Assuming one coin comes crashing down, you can rest easy knowing that a good amount of your investment lies in other cryptocurrencies.
To put this in context, let’s assume you invested all of your deposit in Ripple (XRP), and it suddenly drops by 50%; you’d lose half of your investment.
However, if you had ten crypto assets, and Ripple was only 10% of your investment, then the loss on your portfolio will be less significant.
Never ignore risk diversification, always spread out your investment no matter how stable a coin may seem.
Estimating the size of the trade
The second principle of risk management is estimating the size of the trade. Oftentimes, traders are guided by sentiments and emotions rather than logic and serious calculations.
There is even a special term to describe this phenomenon, and it’s called FOMO (fear of missing out). Inspired by all the hype that is common on social media, traders often behave recklessly by investing over 45% of their deposit in one deal. This is an extremely risky thing to do and can lead to serious losses when a trade fails.
You should always keep the 6% rule and the 2% rule in mind whenever you are making a deal. The latter says that you should only open a position with no more than 2% of your entire deposit. Some experts even recommend that you open a trade with only 1% of your deposit. This strategy will ensure that you are never liquidated.
The 6% rule on the other hand says that if you keep losing money in crypto trading and can’t stop a streak of unsuccessful trades, then you should stop trading once you have lost up to 6% of your total deposit. In this case, it is advisable to take a break from trading and wait two weeks so you can psychologically recover and stop making rash decisions.
Determining the trade profitability
The third key principle of risk management is the determination of trade profitability. Remember that not all trades will be profitable, and even expert traders lose money.
What you want to pay attention to is the profit to loss ratio. The ideal profit to loss ratio should be 3:1 or at least 2:1.
You can manually calculate your profit to loss ratio by taking the average profit from all successful trades divided by the average losses on all unsuccessful trades over a set period.
Learning from your mistakes is great, but it is also an expensive way to succeed. A standard example is when you lose a trade and you decide to invest twice the amount you invested on the last trade to compensate for the loss. This is a rash decision that could lead to you losing more money. Don’t do this!
Record your losses and don’t allow yourself be blinded by greed. Self-confidence in crypto trading is an important skill, but overconfidence can play tricks on you that could lead to huge losses.
Setting Stop Loss Orders
A Stop-loss order is an instruction to the exchange to close a trade when a certain loss level is reached.
For example, if you buy some Ethereum (ETH) for $2,000, and your technical analysis predicts that the price of the coin will rise, you can give a command to the exchange that if the price of ETH should drop to $1700, then it should be sold so it doesn't dip further and lose more value.
This is where most traders make mistakes. Many newbies and experts don't know how to close deals and take profit when a certain level of profit is reached in a trade.
Greed never leads to good outcomes. It's always good to establish your take profit margin level and close the trade upon reaching it. The price level can turn around at any time and you could be left with nothing but regrets.
Trading cryptocurrency has a lot of benefits especially when managed properly but it can also lead to losses if you don't follow set principles. What other risk management measures do you put in place when you trade crypto?
Disclaimer: This article was written by the writer to provide guidance and understanding of cryptocurrency trading. It’s not an exhaustive list and should not be taken as financial advice. Obiex Finance will not be held responsible for your investment decisions.