Risk Management is everything. It helps you prevent losses, preserve capital, and maximize profits. A risky investor is a profitable investor, but unless you manage risk, you’re bound to end up with more losses than profits. And in a volatile sector such as crypto, deleting every bit of risk matters.
Today’s article tackles proper risk management in crypto markets and shows you various ways of trading, or investing, responsibly. Learn how to hedge investments, rebalance portfolios, use stop loss orders, do your own research, and more.
What Is Risk Management?
Risk management involves taking the required steps needed to predict, curb, and remove or minimize financial risk. Your job as an investor is to go head first against risk in order to have a chance at profiting from the market. But although some level of risk-taking is required, you must also learn to control your risk exposure.
Let’s say I have invested 50% of my portfolio into Bitcoin and the other half into traditional stocks. One day the stock market begins to tumble while the crypto market holds its breath. Because cryptocurrencies are more speculative assets compared to other financial markets, my first step is to minimize my crypto exposure.
By decreasing my exposure to digital assets I will take on the existing risk of holding TradFi assets that have already taken a fall, while also removing the chances of taking more losses through a potential dump in crypto markets. Decreasing risk in this scenario might take the form of converting my crypto assets into stablecoins or by hedging against the market by shorting.
Learn more about crypto risk management: Maintaining Risk and Discipline
Risk management can also take place when you have a position that’s in profit. For example, you might have a good position in DOGE, and months later, the asset dramatically jumps in value. You refuse to take profit thinking that the asset is bound to jump in price. However, the asset ends up facing buyer exhaustion and tumbles. Your portfolio loses an astonishing chunk of its value by refusing to take profits at the top.
Incorporating Risk Management in Crypto
Incorporating good risk management practices in your crypto investments is no small feat. You need years of experience to even conceptually grasp what risk management entails. And even then, you will have to spend countless nights constantly reminding yourself to put your knowledge of risk to good use.
Risk management can be something as small as doing a double check on an investment or trade. Let’s say that your technical or fundamental analysis led you to believe that a cryptocurrency might jump in price. You know that you need to open a long position or allocate a notable amount of capital within your portfolio to the asset in question. But how do you control your risk exposure?
For example, you might want to plan your trade out. What happens when price hits point A and what happens when it hits price B? You should know when to take profit and when to exit the trade. You can do both by applying stop loss and take profit orders respectively.
Moreover, you can add layers of risk management. You can open the long position like described before, and add an additional layer of protection by hedging your trade. You would do that by longing or shorting a different asset.
The best description of good risk management would be having a plan. You need to know what to do in each situation, analyze investments, and conclude a set of rational outcomes based on the decision you take. By doing so, you will always know what to do next, saving yourself from ending up in a situation you didn’t expect or predict.
5 Key Risk Management Tips for Crypto Investments
There are too many ways of integrating risk management into your crypto activities. But for the sake of this article, I’ll give you, what I believe to be, the 5 best risk management tips for minimizing your exposure to bad risk.
1. Hedge Your Investments
Hedging is the best way to minimize risk. Hedging is an advanced trading technique that combats risk with the help of inversely correlated assets. For example, a leveraged long position can be hedged with a leveraged short position. Investing in one crypto niche sector can be hedged by investing into another one, and so on.
What hedging accomplishes is minimizing risk by reducing your exposure to one-sided trades. Rather than betting all in on one position, you take into consideration that your trade might end in the wrong direction. However, the downside to hedging is that you reduce your potential profits by always ending up with a losing trade.
You can combat the downsides of hedging by playing around with position sizes. If you have more reasons to believe that Bitcoin will jump in value, open a long position worth 1 BTC, and a short position worth 0.5 BTC. That way, you improve the profitability of your worst-case scenario.
2. Diversify & Rebalance Your Portfolio
Portfolio diversification is a popular strategy in managing risk exposure. Diversification allows you to control risk by frequently changing asset allocations in line with how the market changes. For example, if one asset suddenly jumps in value, you can take profit on that asset and redirect those profits into lagging assets – underperforming cryptocurrencies.
Those underperforming cryptocurrencies will eventually catch up and bring far higher profits compared to assets that performed well. Moreover, you’ll also avoid a nasty situation by taking profits on time on the asset that showed good results.
Portfolio rebalancing is a popular tactic that has several benefits for risk management. Rebalancing works by periodically adjusting your asset allocations and moving profits around. You can pick between periodic and threshold-based rebalancing – the two most popular rebalancing strategies in crypto.
You can apply diversification in ways other than tackling asset allocations. For example, you can expose yourself to a larger number of asset categories. If most of your portfolio is in smart contract ecosystems (Ethereum and Solana), you might want to pick your next investment in something else. Exposing yourself to more use cases brings the benefits of reducing your risk of limiting yourself to a use case that can potentially fail.
3. 1% Trading System
Now this rule is for trades (mostly day traders) only. A strategy that many day traders follow is the 1% rule. The rule entails not risking more than 1% of your portfolio on a trade. Let’s say your portfolio is worth $100,000. Applying the 1% rule means not risking more than $1,000 per trade.
The benefit of the 1% trading system is that you minimize your risk by using smaller position sizes. If you traded larger positions, like $10,000, you would only need 10 bad trades to lose all your money in the previous scenario. So by trading $1,000 per trade, you technically give yourself 100 chances to succeed. Trust me, 100 trades is a really low number and you should feel worried.
But there’s a small hack you can use to make your position size larger while carrying the same risk. It might sound impossible, but it’s actually rather simple: use stop loss orders! You can open a position worth $10,000 and add a stop loss order that cuts your trade early after losing 10%. That’s how you only risk $1,000 per trade. Sounds amazing, right?
4. Do Your Own Research (DYOR)
The easiest way to keep your investments under control is to do your own research (DYOR). DYOR is a crypto mantra that advises researching everything alone, rather than relying on other people’s opinions, beliefs, and research. Conducting your own research is essential to minimizing risk as it allows you to avoid misinformation, bad data, and irrational conclusions.
DYOR is part of every investor’s due diligence system. DYOR can be as simple as fact-checking a simple piece of data, or as complex as spending weeks meticulously researching an altcoin project. Such research entails reading white papers, checking out roadmaps, interacting with the community, and inspecting the team.
No time spent in crypto is wasted. Information is key to good investing, and the best way to obtain quality information is by finding it yourself. Be you a noob or a veteran, DYOR is mandatory for a profitable investing experience.
5. Use Stop Loss (SL) and Take Profit (TP) Orders
You’re a mere beginner if you only know about limit and market orders. There’s much more to investing than clicking the buy and sell buttons. Careful investing that focuses on minimizing risk should always contain at least a stop loss or a take profit order.
SL and TP orders contain risk by enabling you to exit the trade when either at a loss or in profit. SL orders help you get out of a trade once you lose a certain percentage of your position. For example, you can limit risk by exiting your position after a 5%, 10%, 15%, or 20% loss.
Read my simple guide to stop loss orders
TP orders do the same but on the opposite spectrum. Taking profits enables you to secure your trade by preventing you from becoming greedy. You plan out a trade, decide how high the asset can increase in value (while being realistic) and decide ahead of time when you’re going to exit the trade. Greed is every man’s downfall, so ensure you’re a profitable man, and not a greedy one.
Is Crypto Risk Management Really That Important?
Risk management is the defining feature of a long-lasting investor. The veteran investor knows exactly how much to expose himself to risk. He does so without dramatically limiting his potential for profits. The investor that utilizes proper risk management will remain a market participant for years, while his counterpart will not last longer than his portfolio allows him to.
Risk management in the crypto market is an effective way to curb the effects of bad volatility. Proper risk reduction helps you survive the market for longer and minimize your losses. There are numerous ways to conduct good risk management, but the simplest tips are often the most effective ones.
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