How do you manage risk in a market that offers up to 200x leverage? Or where exchanges liquidate billions of dollars overnight?
Many claim that capital protection equals success in investing markets. In a world where 90% of traders lose money, dealing with risk and trade management is a requirement before opening any position.
Invest more than you can afford to lose is a phrase you might have heard. But although sound advice, risk management is much more than capital allocation. You need to calculate the risks and rewards of each trade and manage position sizes.
In this article, I show you the basics of risk management and teach you how to accomplish the main goal of a day trader: surviving the market.
Why Manage Risk?
Why focus on capital protection when you can regain losses by chasing profits? Isn’t it more valuable to spend time finding clear setups and new ways to improve your portfolio?
If you follow analysts who post their charts online, you might arrive at the same conclusion. They always enter new setups and post wins. Never have you seen them lose on a trade or care about something as insignificant as risk management. But is reality that black and white? It’s time for a short history lesson.
In World War 2, the American army noticed an uptick in the number of bombers shot down above Germany. Their researchers analyzed the bombers that returned safely and discovered what made them structurally vulnerable, mapping out their bullet holes.
The bombers had bullet holes on the wings and the body of the plane, so the solution was obvious: increase the armor on those parts.
When a statistician named Abraham Wald took a second look at the data, he realized that the analysis was all wrong. The researchers only analyzed bombers that had returned to their bases. There was no data on planes that were shot down. It turned out that the engine, cockpit, and parts of the tail were the most vulnerable parts.
This logical error is what we call survivorship bias. You never hear about the traders who blew their account by mismanaging risk. They chase profits and feel confident in a predictable market, only to lose money when the market eventually changes.
To make matters worse, trading influencers delete their bad takes, leaving you with no idea what kind of mistakes cost them money. You’d think that these people wouldn't have to charge $1000 trading courses having a 100% win accuracy.
Beginners often think about how much money they can make when opening a trade, but it’s time to change that mindset: focus on improving your chances of survival. Thinking about the scary 90% trading (un)success statistic might help.
Crypto Tips for Risk Management
The other day ago, a friend of mine told me that his February profits were erased. He’s an experienced trader who has been learning his craft since 2017, but a moment of carelessness was all it took to set his progress one month back. Refusing to take a calculating approach cost him both time and money, and his experience didn’t make him immune to the shortcomings of bad risk management.
Crypto trading is vicious, and the rules change all the time. Someone can trade profitably for a month only to lose trade by trade the next month. You can never relax, but you can make your job easier by practicing a few risk strategies and adopting a healthy and disciplined mindset. Here are some strategies you can use to trade almost risk-free.
Never invest more than you can lose. You’ve heard this more times than you can remember. But what’s the deal with capital allocation? Is it the total amount of money you’re willing to lose, or is it something else?
Let’s say you have $10,000 and have spotted a wonderful long opportunity. You’re confident that Bitcoin will bounce from the lows, perhaps too confident. You open Binance Futures, select 10X leverage, and adjust your trade size.
Will you invest all $10,000? Of course not.
What about $5,000? Nope, that’s still 50% of your portfolio. Losing $5,000 requires you to double your profits to break even.
A good measure for capital allocation falls between one and five percent. The less money you risk the better, especially if you’re new to the game. Even something as small as 5% means you’d only have to lose 20 trades to turn $10,000 into $0.
The goal is to survive the market, and there’s no better way to keep trading than by maximizing sustainability. There will come a time when you’ll face losing streaks, so trade safely by allocating minimal capital. Crypto traders might flash their big position sizes like TradFi traders flash watches, but that’s not for everyone.
Calculating Risk/Reward Ratio
When I mentioned taking a calculating approach a few moments ago, I meant that literally. I encourage you to calculate your R/R (risk to reward ratio) before entering any trade.
Think of trading as playing slot machines. One slot machine has a 1.5 win/lose ratio every time you play and the other has 1.75. Which one will you play?
R/R represents the risk you’re undertaking for a potential reward. Trades with higher R/R are better because you earn more money for the same or lower risk.
Let’s say your R/R is 1:2. You have one unit of risk compared to two units of rewards. A practical example would be shorting Bitcoin at $40,000 with a target at $36,000 and stop loss at $42,000. The entry is only $2000 away from the SL, but $4000 from the target.
The formula for calculating risk is: (Target — Entry)/(Entry — Stop Loss). But instead of calculating R/R manually you can use TradingView’s tools for short and long positions.
Use a Stop Loss Order
You might have noticed that every setup has a target price with a corresponding stop loss. This is the price level at which you’ll close your position to protect your capital. Note that when you enter a trade, you don’t risk the entire sum, but only a part of it. (e.g. 10% of $500).
You can always close positions manually, but the best way to go about it is setting a stop loss order which automatically closes the trade at the selected price level. This is useful when trading with leverage because these orders prevent you from liquidating your account or when holding a trade overnight.
The point of a stop loss is to close the position the moment your trade thesis is invalidated. For example, if you’re longing support in hopes that it will hold, it’s normal to close the trade immediately if the support level breaks.
Next time you open a new trade, don’t forget these rules:
Pick an appropriate capital allocation
Chase trades with good R/R balance
Always use stop loss orders
These three tips help boost your risk management skills and ultimately, your survivability. If you’re new here you should minimize risks – not maximize profits.
If you want to learn more about managing risk, I recommend checking out the following resources:
Marko is a crypto enthusiast who has been involved in the blockchain industry since 2018. When not charting, tweeting on CT, or researching Solana NFTs, he likes to read about psychology, InfoSec, and geopolitics.