Can people stand losing money? Of course not. Nobody likes losing their money. But then, why does it happen to the majority of traders? Why does it happen to me? And I think it’s very likely that it happens to you too, doesn’t it?
I think that we are not asking the right questions here. The right questions that lead us on a constructive path. They should allow us to improve upon what we have. And should be about something that we can control. Ourselves. So, maybe, it’s not “why does it happen to me?”, it’s more like “why did I do it?”
Taking responsibility will allow us to have a good and strong start in our endeavor today to tackle the subject of risk management.
It’s never advised to enter a position in trading before knowing exactly what your risk to reward ratio is. This does NOT mean if the risk justifies the reward or if the reward justifies the risk. I hear people explaining it this way a lot. But I think that this could be misleading, if you put it like that. I want to propose to explain it this way: what your risk to reward ratio is means that you should ask yourself a question. Are you prepared to definitely lose a certain amount of money in order to have a chance at winning more than what you invested?
Ask yourself this question before every trade you want to open. Don’t cherry pick. Remember, taking responsibility. And I assure you, you’re going to see a huge difference in the quality of your trading decisions.
Now, we're going to take this a step further and delve into the world of risk management some more. Questions are our beacon. So, let’s start by asking one.
What are the main types of risk when trading cryptocurrencies? “Know thy enemy”, right? Risk means losing and losing is the enemy. You can win by losing less. It’s the name of the game. Even professional traders are not always right. So, best case scenario. A certain period of time from now, you’ll start losing a lot less than what you’re losing right now. That’s how you win in the trading world. You win some, you lose some. But you should come up on top on the long run.
There are five main types of financial risk inherent to cryptocurrency trading.
Market risk Market risk is the risk of losing due to what’s affecting the market as a whole. To put it simply, it’s when the coin prices move against your desired direction, whether it be up or down. Which I think is the case we’re most familiar with.
As it’s a risk that is omnipresent, you too should keep it in mind and always be prepared for it.
2. Operational risk It’s when you are unable to trade or transact with your crypto wallet due to errors, system failures or any event that could disrupt the infrastructure put in place to secure transactions on the crypto market.
3. Liquidity risk Liquidity means cash. That’s why liquidity risk for cryptocurrencies refers to the inability of converting your entire position to fiat currencies.
4. Credit risk Credit risk is when you incur a loss due to the inability of a borrower to repay a loan.
So, how does that affect you?
Behind every cryptocurrency there’s a project. And sometimes, the team behind the cryptocurrency can fail to meet its obligations. That’s a red flag. It could happen due to theft or fraud. But when it does, it leads to huge losses for all parties involved in the project.
5. Legal Risk This happens when the project faces legal issues. Like a ban on cryptocurrency trading in a certain country. Here we can site the famous ban on Bitcoin by the Chinese government that started in 2013.
Now that we know the main types of risk that we are facing, we could ask ourselves another more practical question.
What risk management practices I can do to mitigate my losses? For optimal results, these practices are to be implemented in every trade.
Position sizing It means knowing the size of the trades you want to open. In other words, it’s the quantity of a crypto-asset that you’re going to either buy or sell.
If you want to buy a cryptocurrency, your position size can be obtained with this formula:
Position Size = (Account Size * (Risk X 00.1)) / (Entry Price - StopLoss price) X Entry Price
The part: (Account Size * (Risk % X 0.01)) determines the maximum amount you’re willing to risk on that trade.
For the second part: (Entry Price – Stop-loss Price). This is the amount you would lose if your stop-loss was triggered.
And if you want to sell a cryptocurrency, the formula must change a bit. It becomes:
Position Size = (Account Size * (Risk X 00.1)) / (StopLoss Price - Entry Price) X Entry Price
The explanation of the main two parts that compose this formula stay the same.
Also, one of the main benefits of position sizing is that it helps you clearly define your stop-loss levels.
Risk per trade It’s your risk tolerance. Called also risk appetite. It’s the risk% part in our formula.
To stay in the game for the longest time possible, it’s advised to fix your risk percentage in between 0.1% and 4%. There’s a sweet spot there, but it’s up to you to find it. Through experience and according to your own specific circumstances. The most important thing is just to play it safe.
Take profit level It’s good to let the winners run. However, as long as your money is out of your pocket, there’s a risk of losing it. That’s why it’s crucial to not let your trades run forever. You should take profit at a certain level.
You can find out where your profit level should be by analyzing different scenarios of risk to reward ratios and finding out what most suits your strategy.
For instance, a risk to reward ratio of 1:2 means that you want your take profit level to be twice what you’re risking to lose.
Risk to reward ratio Risk to reward ratio can be calculated as follows:
For example, if you wanted to buy ETH at the price of 3,000 USD with a stop-loss at 2,500 USD and a target price of 4,000 USD, then by applying what we have just learned here:
(3,000-2,500) /(4,000 – 3,000) = 1:2
So, with these stop-loss and take profit levels, you’re risking half of what you’re aiming to gain.
These four main risk management techniques can help you avoid many bad trades. Thus, put back money in your pocket that you could have lost otherwise. And when coupled with the right mindset, they can greatly improve your account.
Risk is an unavoidable aspect of trading. You can’t take it out of the game. You can only learn to better manage it. Accept your failures and don’t rely on emotions to steer your account into bankruptcy. Have a plan-based algorithm instead that will help you realize consistent profits.
And with this we come to the end of this articles. Which is purely educational and should never be taking as financial advice. You’re the only one responsible for the money you put into your trading. So, please be careful. Better be safe than sorry.