The market for digital assets is still young, so volatility is a natural part of this market. Before wanting to enter the game for the first time, it is necessary to take into account that this market is prone to irrational phenomena.
The market for digital assets is still young, so volatility is a natural part of this market. Before wanting to enter the game for the first time, it is necessary to take into account that this market is prone to irrational phenomena.
Diversification is a key part of risk management, but is it really important to be exposed to a variety of assets and Cryptocurrencies?
The answer is yes, it is worth diversifying investments to mitigate risk.
Trading cryptocurrencies using a spread betting or CFD trading account can be much safer than investing directly in crypto through a digital wallet for several reasons.
When you own cryptocurrencies, you are at the mercy of price swings, which can be sudden and significantly change the value of your investment. You will also have to open a digital wallet, which can be difficult to set up and manage and weigh the risks of possible cyberattacks on the cryptocurrency exchange.
However, when you trade cryptocurrencies through CFDs or spread betting you will have access to the same risk management tools as when you trade any of our other major assets. This can help you enjoy the same market opportunities, with less exposure to risk.
The rules of the risks associated with trading cryptocurrencies are not impossible to follow. In this article, we will talk about risk trading and how to manage your cryptocurrencies safely.
Risk refers to the probability that a negative event will occur in your activities, an event that is contrary to the results you had anticipated. Risk is an integral part of cryptocurrency trading It is the possibility of an unwanted result during trading, which translates into losses. For example, a 50% risk on a short position simply means that there is a 50% chance that the price of bitcoin will go up, causing you to lose.
In this article, we will teach you the simple rules that you must follow when managing risk in cryptocurrency trading.
Risk Types
The world of cryptocurrency trading is vulnerable to four main types of financial risks:
Credit risk
This risk affects cryptocurrency projects. It is the probability that the parties behind the cryptocurrency project will not meet their due obligations. Credit risk is mainly attributed to theft and fraud in the cryptocurrency market.
Legal risk
Legal risk refers to the probability that a negative event-related to regulatory standards will occur. For example, the prohibition of cryptocurrency trading in a certain country. A practical example of legal risk is when the states of Texas and North Carolina issued a cease and desist order for the Bitconnect cryptocurrency exchange due to suspected fraud.
Liquidity risk
In cryptocurrency trading, liquidity risk refers to the possibility that a trader cannot convert his entire position to a fiat currency (USD, YEN, GBP) that can be used for daily expenses.
Market risk
Market risk refers to the possibility of currency prices going up or down against a position you have opened.
Operational risk
Operational risk is the possibility that a trader cannot trade, deposit or even withdraw money from their cryptocurrency portfolio.
Main Risk Management Strategies
The general rule of thumb in cryptocurrency trading is: “don’t risk more than you can afford to lose.” Given the severity of risk in cryptocurrency trading, we normally recommend traders not use more than 10% of their monthly budget or income. Also, it is not advisable to use borrowed money for trading, as this puts traders in a position of credit risk.
Risk management strategies can be classified into three categories: risk/reward ratio, position size, and stop loss and take profits.
1. Position size
The size of the position dictates the number of coins or cryptocurrency tokens that a trader is willing to buy. The possibility of making big profits from cryptocurrency trading tempts traders to invest 30%, 50%, or even 100% of their trading capital. However, this is a disruptive move that results in serious financial risks. The rule of thumb is: never put all your eggs in the same basket. Here are three ways to determine position size.
Entry price vs. the amount to risk
This approach considers two different quantities. The first is the money you are willing to invest in each operation. Traders should consider this amount as the size of each new position they open, regardless of its type. The second represents the risk money, that is, the money that you can lose if the operation fails.
The entry price is calculated in this way:
A = ((Stack size x Risk per trade) / (Entry price – Stop Loss)) x Entry price
Let’s say we want to buy BTC with USD with a target of $ 13,000. Our parameters would be:
Stack size: $ 5,000
Risk per operation: 2%
Entry price: $ 11,500
Stop Loss: $ 10,500
Our entry price would be:
A = ((5,000 x 0.02) / (11,500 – 10,500)) * 11,500 = 1,150
The ideal amount to invest in this operation would be $ 1,150 or 23%. However, due to our Stop Loss, we only risk 2% as the trade will stop once it reaches the set level.
Risk trading in cryptocurrency
Elder’s “sharks” and “piranhas”
This concept of position size is related to the diversification of your investments. This concept is attributed to Dr. Alexander Elder, who suggests two rules:
- Limit each position to 2% risk. Elder compares the risk to a shark bite. Sometimes you want to risk a very large amount, but the risk would be great and catastrophic, like a shark bite.
- Limit trading sessions to 6% per session. If you are going through a losing streak, you may gradually end up spending everything you have. Elder compares this risk to attacks by piranhas, which take small bites from their victim until they are all consumed.
Following Elder’s Sharks and Piranhas approach, the result is no more than three open positions at 2% each or six at 1%. By limiting the results with a reverse compounding, the losses get smaller and smaller with each subsequent loss you suffer.
Kelly’s criterion
Developed in 1956, the Kelly Criterion is an accurate formula given by John Larry Kelly. It is a position sizing approach that defines the percentage of capital to bet. It is suitable for long-term trading.
A = (% Success / Loss Rate in Stop Loss) – ((1 -% Success) / Profit Rate in Take Profit)
Using the previous example, the characteristics would be:
Stack size: $ 5,000
Amount invested: $ 1,150
% success: 60%
Entry price: $ 11,500
Stop Loss: $ 10,500
Loss rate: 1.10
Take profits: $ 13,000
Our result would be:
A = (0.6 / 1.10) – ((1 – 0.06) / 1.13) = 0.19
This means that you should not risk more than 19% of the total capital of $ 5,000 to obtain the best possible result in a series of operations.
2. Reward/risk ratio
The risk/reward ratio compares the actual level of risk with the potential returns. In trading, the riskier a position is, the more profitable it can be. Understanding the risk/reward ratio allows you to know when to open a position and when it is not profitable. The reward/risk ratio is calculated as follows:
R = (Target Price – Entry Price) / (Entry Price – Stop Loss)
Taking into account the above:
Entry price: $ 11,500
Stop Loss: $ 10,500
Target price: $ 13,000
Our relationship would be:
R = (13,000 – 11,500) / (11,500 – 10,500) = 1.5 or 1: 1.5
A 1: 1.5 ratio is good. We advise traders not to trade less than 1: 1.
3. Stop Loss + Take Profit
Stop Loss refers to an executable order that closes an open position when the price falls below a certain limit. On the other hand, Take Profit is an executable order that liquidates open positions when prices rise to a certain level. Both tools are very good at managing risk. Stop Losses prevent you from making unprofitable trades, while Take Profits allow you to exit a position before the market turns against you.
You can use Trailing Stop Loss and Take Profits that follow rate changes automatically. However, this feature is not available on most cryptocurrency exchanges. Luckily, using terminals like Superorder, you can configure your Trailing Stop Losses and Take Profits directly from the terminal.
Winning Strategies:
Accept failures
Risk is part of trading. Also, we cannot delete it, we can only manage it. Therefore, you must accept your losses and make decisions based on a plan to profit from future operations.
Take into account the commissions
New traders are often unaware of the commissions involved in trading. These include withdrawal fees, leverage fees, etc. You must take all of this into account when managing risk.
Focus on profits
The risk will always be present to discourage you when it comes to trading. However, focusing on the number of times you win will help you develop a positive attitude in trading.
Measure losses
This refers to the total decrease in your initial funds after a series of losses. For example, if you have lost $ 1,000 out of $ 5,000, the loss will be 10%. The higher the amount, the more you will need to inject in an operation for it to recover. As Dr. Elder advises, the risk limit should be kept at 6%.