Risk refers to the probability of a negative event happening in your activities; an event that goes contrary to your intended outcome. Risk is part and parcel of the cryptocurrency trade. It is the chance of an undesired outcome on the trade, which translates to making losses. For instance, a 50% risk on a short position simply means that there is a 50% probability that the Bitcoin price will rise, resulting in a loss on your part.
Today, we take you through the simple rules to follow when managing risk in crypto trading.
Types of Risk
The crypto trading world is exposed to four main types of financial risks:
This risk affects crypto projects. It is the probability of the parties behind the crypto project failing to fulfill their due obligations. Credit risk is mostly attributed to theft and fraud in the crypto market. A good example is the hacking of Binance in 2018, which led to over $40 million loss.
Legal risk refers to the probability of a negative event occurring with respect to regulatory rules. For instance, a ban on cryptocurrency trading in a specific country. A practical example of legal risk is when the states of Texas and North Carolina issued a cease-and-desist order to Bitconnect cryptocurrency exchange due to suspicion of fraud.
Liquidity risk in respect to crypto trading refers to the chance of a trader being unable or incapacitated to convert their entire position to fiat currencies (USD, YEN, GBP) that they can use in their every-day spending.
Market risk refers to the chance of coin prices moving up or down contrary to your desire in an open position.
Operational risk is the chance that a trader is unable to trade, deposit, or even withdraw money in their crypto wallets.
Main Risk Management Strategies
The rule of thumb in crypto trading is: “Do not risk more than you can afford to lose.” Given the gravity of risk in crypto trading, we generally advise traders to use not more than 10% of their budget or monthly revenue. Also, trading with borrowed money is not advisable as it puts them in a credit risk position.
Risk management strategies can be broadly categorized into three: risk/reward ratio, position-sizing, as well as stop loss & take profits.
1. Position Sizing
Position sizing dictates how many coins or tokens of cryptocurrency a trader is willing to buy. The probability of realizing great profits in crypto trading tempts traders to invest 30%, 50% or even 100% of their trading capital. However, this is a disruptive move that puts you at serious financial risks. The golden rule is: never put all your eggs in one basket. Here are three ways to achieve position sizing.
Enter Amount vs Risk Amount
This approach considers two different amounts. The first involves money you are willing to invest in every single deal. We advise traders to look at this amount as the size of each new order they take, regardless of its type. The second involves money at risk, i.e. the money that you stand to lose in case the trading fails.
This is how you define your enter amount:
A = ((Stack size * Risk per Trade) / (Entry Price – Stop Loss)) * Entry Price
Let’s say we wish to purchase BTC with USDT with a target of $13,000. Our parameters would be:
- Stack Size: $5,000
- Risk per Trade: 2%
- Entry Price: $11,500
- Stop Loss: $10,500
Our enter amount would be:
A= ((5,000 * 0.02) / (11,500 – 10,500)) * 11,500 = 1,150
The ideal amount to invest in this deal is $1,150 or 23%. However, due to our Stop Loss, we only risk 2% as it will stop the trade once it reaches the determined level.
Elder’s “Sharks” and “Piranhas”
This concept of position sizing relates to diversifying your investments. Dr. Alexander Elder, who is credited with the concept, suggests two rules:
- Limiting every position to 2% risk. Elder compares risk to a shark bite. Sometimes you would wish to risk a huge amount, but the risk would be huge and catastrophic as a shark bite.
- Limiting trading sessions to 6% per session. In a losing streak, you may end up spending everything you own little by little. Elder compares this risk to a piranha attack, which takes small bites of its victim until it consumes it all.
Following Elder’s sharks and piranhas approach results in no more than three open positions per 2% each or six ones per 1%. Limiting results in reverse compounding; losses get smaller and smaller with each subsequent loss you make.
The Kelly criterion is a formula developed by John Larry Kelly in 1956. It is a position sizing approach that defines the percentage of capital to bet. It suits long-term trading.
A = (Success % / Loss Ratio at Stop Loss) – ((1 – success %) / Profit Ratio at Take Profit)
Using the previous example, the features would be:
- Stock size: $5,000
- Invested Amount: $1,150
- Success %: 60%
- Entry Price: $11,500
- Stop Loss: $10,500
- Loss Ratio: 1.10
- Take Profits: $13,000
Our result would be:
A = (0.6 / 1.10) – ((1 – 0.06) / 1.13) = 0.19
This means you should not risk more than 19% of the entire capital of $5,000 for you to arrive at the best possible outcome in a series of deals.
2. Risk/Reward Ratio
The risk/reward ratio compares the actual level of risk with the potential returns. In trading, the riskier a position, the more profitable it can get. Understanding the risk /reward ratio enables you to know when to enter a trade and when it is unprofitable. The risk/reward ratio is calculated as follows:
R = (Target Price – Entry Price) / (Entry Price – Stop Loss)
From the previous illustration:
- Entry price: $11,500
- Stop Loss: $10,500
- Target price: $13,000
Our ratio would be:
R = (13,000 – 11,500) / (11,500 – 10,500) = 1.5 or 1:1.5
A ratio of 1:1.5 is good. We advise traders not to trade with a ratio lower than 1:1.
3. Stop Loss + Take Profit
Stop Loss refers to an executable order which closes an open position when a price decreases to a specific barrier. Take Profit, on the other hand, is an executable order that liquidates open orders when the prices rise to a certain level. Both are good approaches to managing risk. Stop Losses save you from trading in unprofitable deals while Take Profits let you get out of the trade before the market can turn against you.
You can make use of Trailing Stop Losses and Take Profits which follow the rate’s changes automatically. Such a feature, however, isn’t available at the majority of crypto exchanges. Fortunately, with crypto terminals like Superorder, you can set your Trailing Stop Losses and Take Profits right from the terminal.
Risk is part and parcel of trading. Besides, we cannot eliminate it but only manage it. You should, therefore, accept your losses and rely on plan-based decision making to realize profits in future trades.
New traders often do not know the fees that come along with trading. Such include withdrawal fees, leverage fees, etc. You should consider these in your risk management.
Focus on the Win Rate
Risks will always be there to discourage you from trading. However, focusing on the number of times you win helps to develop a positive attitude in trading.
This refers to the total reduction of your initial funds after a series of losses. For instance, if you lost $1,000 from $5,000, your measure drawdown is 10%. The higher the amount, the more you would need to inject into a trade for it to recover. As Dr. Elder advised, stick to a 6% risk limit.