Real Examples of Risk Management Strategies When Trading Crypto
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Effective risk management is not just a recommendation in the crypto trading arena; it's a necessity for survival and success.
Even advanced, professional traders can experience losing trades consecutively up to 10 times. The crucial goal in crypto trading isn’t to always win, it’s to stay resilient despite the losses and keep trading.
Read below for some real-life case studies that highlight the importance of risk management in crypto trading.
The Common Risk Management Strategies Crypto Traders Apply
Your risk management strategy depends on your trading style and risk tolerance. For instance, if you're prepared to lay down 10% of your portfolio on a risky trade on any centralized exchange platform with a 50/50 chance of success, this is generally viewed as a moderate-risk strategy.
However, if you're willing to risk 50% of your portfolio on the same investment, most experts would classify you as having a high risk tolerance and employing an exceedingly risky investment approach.
Additionally, another high risk strategy is the ‘no real plan’ strategy. That means that regardless of how much of your account you’re putting into a trade, without a specific trading plan (e.g. technical indicators combined with candle or chart patterns, news, location of the current market cycle, etc.), you’re taking a high risk.
Thus, it’s important to understand how much of a low-risk or high-risk trader you are first and foremost.
Then, you should learn and apply the basic elements of risk management: diversifying portfolio, applying proper position sizes for your trades, setting stop loss orders, counting probabilities, and many more. They’re all equally important and should be integral to your risk management strategy.
Examples of Risk Management in Crypto Trading
Diversification
Diversifying your investments involves spreading your funds across various assets to mitigate the impact of volatility in any single asset. For example, instead of investing your entire $10,000 into Bitcoin, you could allocate portions to Bitcoin, Ethereum, Litecoin, and other cryptocurrencies. This diversification helps cushion your portfolio against potential losses if the price of a specific asset, such as Bitcoin, experiences a significant decline.
Example:
Let’s say you decide to invest $5,000 in cryptocurrencies. Instead of putting all the funds into a single asset, you diversify your portfolio by allocating $2,000 to Bitcoin, $1,500 to Ethereum, $1,000 to Litecoin, and $500 to Ripple.
The potential outcome?
While Bitcoin and Ethereum experience moderate gains, Litecoin and Ripple outperform expectations, resulting in overall portfolio growth. Your diversified approach helps you mitigate the risk of overexposure to any single asset and capture opportunities across multiple cryptocurrencies.
Position sizing refers to determining the percentage of your portfolio that you’re willing to risk on a single trade. Numerous significant losses stem from improper position sizing in trades, and many traders fail to grasp the repercussions of trading with inadequate size.
A common rule of thumb is to risk only 1-2% of your trading capital on any individual trade. This prudent approach helps manage risk and preserves capital, even if a trade results in a loss.
If your plan is to DCA into your position then it’s common to allocate that 1-2% into all of your orders including DCA orders.
Example:
Imagine you go through 7-8 consecutive losses (which is pretty common) and risk 1% each time. You'll still have around 90% of your initial budget remaining. However, if you risk 2%, you'll be left with only 80% of your initial budget, meaning you’ll have to acquire gains of up to 20% to recoup the losses.
Even if you experience 50 consecutive losses (an unlikely scenario), risking 1% per trade will still leave you with 63% of your budget intact.
Implementing stop-loss orders involves setting a predetermined price at which your cryptocurrency assets will be automatically sold if the price falls to that level. This strategy helps limit potential losses by ensuring that you exit a trade before significant losses accrue, thus protecting your capital from adverse market movements.
Example:
Imagine an experienced cryptocurrency trader decides to invest in Bitcoin when its price is $50,000 per coin. He sets a stop-loss order at $49,000 to limit potential losses in case the market moves against him.
The potential outcome?
A few days later, Bitcoin's price experiences a sudden drop due to market volatility, falling to $49,200. The trader’s stop-loss order automatically triggers, selling his Bitcoin at $49,000 per coin. Although the trade incurred a loss, the risk was limited, preserving a significant portion of the investment capital.
Key takeaway: setting stop-loss orders is a crucial risk management strategy that helps you protect your investments and minimize potential losses during market downturns.
Emotion management and discipline
Imagine the scenario of a novice trader who becomes emotionally attached to his investments and fails to adhere to his trading plan. Despite experiencing multiple losses, he continues to hold onto losing positions, hoping for a turnaround.
The very likely result in this case is a significant loss, as this trader fails to cut his losses and exit losing trades on time. His lack of discipline and emotional control ultimately jeopardize his trading capital and hinder his long-term success in crypto trading.
When it comes to managing your emotions and discipline in your trades, you should also take the time to self-reflect and answer these questions:
a) do you routinely enter a trade with real money out of boredom or inactivity?
b) have you risked more than usual because you lost money on your last few trades?
c) have you decided to stop using a strategy because it hasn’t worked on your previous trades?
d) do you believe people who argue that they make 40% profit in a week are great traders?
e) have you thought about quitting trading after a win because you fear you might lose what you just won?
f) have you moved a stop loss to break even just because you couldn’t accept a loss at that time?
Summing up, emotion management and discipline are critical aspects of risk management in cryptocurrency trading. You should stay objective, stick to your trading plans, and avoid making impulsive decisions driven by fear or greed.
Key Takeaways
These are just a few examples of strategies that can help you navigate the treacherous waters of the crypto market. In various trading styles, a trader's foremost responsibility is overseeing the risks linked with each trade. This includes pinpointing ideal exit points for losing positions while enabling profitable ones to flourish.
You can also learn from the experiences of other traders and step-by-step develop a robust risk management framework that allows you to capitalize on opportunities.