Understanding the Risks in Cryptocurrency Trading

Cryptocurrencies introduced a paradigm shift in the financial world and promised users freedom and control. Yet, traders and investors have to rely on third parties like centralized exchanges and wallets, leaving room for risk and potential loss of control over their assets.

Compared to stock trading, crypto trading can be more unpredictable due to the asset class’s relative novelty and the lack of regulation compared to traditional stock markets. 

Here’s an overview of the risks involved with crypto trading and what they mean for your trading journey. 

The Main Risks When Trading Crypto

1. Price Volatility

While it’s widely known that the crypto market is highly volatile, there’s no official indicator that measures crypto price volatility. Crypto traders and investors can only analyze historical price charts that show how peaks and troughs occur at a quicker and more extreme pace in crypto prices compared to prices of assets in mainstream markets.

Cryptocurrencies have large price swings occurring over hours or even minutes. This volatility stems from factors such as market sentiment, regulatory developments, and technological advancements. For example, Bitcoin experienced a 30% price drop on May 19, 2021, following the Chinese government's crackdown on mining and trading activities. Such rapid fluctuations can lead to substantial gains or losses.

Yet, the high risks associated with volatility also present unique insights and opportunities in the crypto market. 

2. Technology Risks 

Technological vulnerabilities inherent in blockchain networks pose risks to traders. Smart contract bugs, protocol flaws, and contentious forks can disrupt trading activities and erode investor confidence. Security breaches can lead to significant losses for traders.

To name just a few of the recent breaches – all due to compromised private keys:

• the Multichain hack (2023) led to a loss of $130 million 
• the Poloniex Exchange hack (2023) where over $100 million was lost
• Atomic Wallet hack (2023) where security vulnerabilities had an estimated loss between $35-100 million.

Thus, staying informed about technological developments is crucial, and in the case of large investments, conducting thorough audits is essential for risk mitigation.

3. Low Liquidity

Although popular cryptocurrencies like Bitcoin and Ethereum enjoy high liquidity, many altcoins suffer from liquidity issues. Trading illiquid assets can lead to slippage and difficulty executing trades at desired prices. 

That’s why you should carefully assess liquidity when choosing which crypto assets to trade.

4. Scams and Fraud

The crypto space is rife with scams, Ponzi schemes, fake ICOs, and fraudulent projects.

The impact of crypto scams extends beyond financial losses. Victims may experience emotional distress and loss of trust in the cryptocurrency ecosystem. Moreover, widespread scams tarnish the reputation of legitimate projects and hinder the mainstream adoption of cryptocurrencies.

Identifying crypto scams requires vigilance and skepticism. Look out for red flags like unrealistic promises of guaranteed returns, pressure to invest quickly, and lack of transparency about the project or individuals behind it.

Legal and Regulatory Risk

The regulations concerning cryptocurrencies are intricate and continuously changing.

Governments and regulatory bodies worldwide are actively monitoring cryptocurrencies. They aim to track transactions, regulate exchanges, and strip encryption protections. While some jurisdictions have embraced crypto-friendly regulations, others have imposed stringent restrictions or outright bans.

In China, the government has outright banned cryptocurrencies. In the United States, the Securities and Exchange Commission (SEC) is considering new regulations that could impact widely traded assets like Ether (ETH) and XRP. Changes in taxation or regulations may affect crypto values and costs.

Additionally, the lack of uniformity in regulations exposes traders to legal uncertainties and the risk of regulatory crackdowns.

Lack of Investor Protection

Unlike traditional financial markets, the crypto market lacks robust investor protection mechanisms. There’s no equivalent to the Federal Deposit Insurance Corporation (FDIC) to safeguard funds, and recourse options in case of fraud or disputes are limited. Traders bear full responsibility for protecting their assets.

This means that you have to rely on the reputation and security of the platforms you use, which may not always be reliable or trustworthy. For example, some platforms may not have adequate safeguards to prevent bad actors from stealing funds, or they may engage in shady practices like market manipulation, insider trading, or exit scams.

If you lose money due to these issues, you may not be able to recover your losses or get any compensation. This is due to the absence of regulatory bodies overseeing the market.

In turn, this lack of regulatory oversight contributes to a lack of transparency in the cryptocurrency market, making it challenging for investors to assess the legitimacy and reliability of projects and platforms.

On the bright side, efforts are underway to address these issues and enhance crypto market integrity.

For instance, the European Commission adopted a comprehensive package of legislative proposals for the regulation of crypto-assets.

In the US, the Infrastructure Investment and Jobs Act was enacted in 2021, introducing the Form 1099-B. This form is meant to provide transparency on the profit or loss incurred from trades through crypto exchanges. 

Tax Implications

Taxation rules regarding cryptocurrencies vary widely across jurisdictions and are subject to change. Traders are required to report their gains and losses accurately, with non-compliance carrying potential legal and financial consequences. 

Here are some examples of worldwide tax implications regarding crypto trading:

United States

In the United States, the Internal Revenue Service (IRS) considers cryptocurrencies to be property for tax purposes. Capital gains tax applies to profits realized from the sale or exchange of cryptocurrencies, with different tax rates depending on the holding period.

United Kingdom

HM Revenue & Customs (HMRC) in the UK has provided guidance on the taxation of cryptocurrencies. Depending on the individual's circumstances, crypto transactions may be subject to income tax, capital gains tax, or corporation tax.

Australia

The Australian Taxation Office (ATO) considers cryptocurrencies as property, subjecting them to capital gains tax when disposed of. Additionally, crypto-to-crypto trades are taxable events, and income tax may apply to mining activities.

Japan

Japan has established clear regulations regarding cryptocurrency taxation. Profits from crypto transactions are classified as miscellaneous income and subject to income tax. However, long-term investors benefit from reduced tax rates.

Germany

In Germany, cryptocurrencies are considered private money, exempt from VAT when used as a means of payment. Capital gains tax applies to profits from the sale of cryptocurrencies held for less than a year, while tax exemptions are dedicated to assets held for over a year.

Tips on How to Handle Crypto Trading Risks

Do your own research (DYOR)

Research serves as the foundation for informed decision-making in cryptocurrency trading. By conducting thorough research, you can gain insights into market trends, evaluate the potential of different cryptocurrencies, and identify potential risks. Successful traders often emphasize the importance of research as a key factor in their trading strategies.

Understanding the fundamentals of cryptocurrency, analyzing market trends, researching the team behind the project, and evaluating the technology and security measures are crucial aspects to explore.

Make sure you get the idea of the Reward/Risk ratio

The risk-to-reward ratio measures the potential gain relative to the amount of capital at risk. While you should customize your risk-to-reward ratio according to your trading goals and chosen strategy, the general advice is that you should only invest what you're prepared to lose. 

The general recommended ratio is 1:1.5, which means you’ll lose a small part of what you invested.

Whereas aiming for a 2:1 ratio means only engaging in trades where the potential reward is double the risk undertaken. 

Align your risk-to-reward ratio with your trading objectives and tactics to maintain a composed approach when entering trades. This ensures clarity on exit points in both favorable and adverse scenarios.

With Altrady’s Risk-Reward Calculator, you don’t have to handle these difficult calculations. Our system will automatically calculate your risk based on your portfolio size, exchange account, or your specified trading amount. 

Diversify your portfolio

Allocating your entire deposit to one cryptocurrency could result in a significant loss if it depreciates sharply. 

Investing in a range of cryptocurrencies can mitigate this risk. By diversifying your portfolio, you spread your investment across multiple coins, lessening the impact of market volatility. While Bitcoin and Ethereum are often seen as foundational assets, you can consider other promising projects with substantial market capitalization. 

That’s why you should conduct thorough market research before diversifying your investments across various cryptocurrencies.

Define your entry and exit strategies

Having clear and well-defined entry and exit points for your trades is paramount. A flawless entry serves as the icing on the cake for a successful transaction, yet it's essential to consider both gains and losses when determining exit points.  For instance, you could enter a trade when a cryptocurrency surpasses a specific resistance level and exit when it reaches a pre-established profit target.

So, plan your exit strategy as part of an effective risk management approach.

The Bottom Line

Crypto trading can be rewarding and exciting, but it’s not for the uninformed. It requires a high level of knowledge, skill, and risk tolerance.

Crypto traders need to do their own research and due diligence before choosing a platform and a strategy. They need to diversify their portfolio and limit their exposure to any single asset or platform. 

In sum, staying informed about market developments, regulatory changes, and technological advancements is crucial for mitigating risks and making informed trading decisions.