A lot of people lose money in the world of cryptocurrencies - that’s nothing new. This is usually a result of practices that look closer to gambling, rather than strategies designed to drive profits consistently. However, it doesn’t always have to be this way.
In order to trade or invest in cryptocurrencies safely, it is important to know how to manage risk. This entails being aware of the potential risks associated with each trade and doing what you can to avoid losing money.
What is risk management in crypto trading?
Risk management in crypto entails practices designed to manage your risk when trading crypto assets. These practices will protect you against the downsides of your trades and help you mitigate any potential losses. Like other assets, risk management is essential in protecting you and helping you gain the desired results when trading crypto.
The need for risk management is heightened for crypto traders, compared to other asset classes. This is because crypto traders tend to experience a lot of overwhelming events such as unusual price spikes, costly mistakes, and even dodgy trading platforms.
If that sounds like you, it's time to assess some risk management practices that, if applied properly, will protect you and help you stay profitable, or at least minimize losses.
Best practices for managing risks when trading crypto
Always have a solid plan
An organised trading plan that informs your entire approach is key.
A great trading plan should inform you:
- When to open trades
- When to close trades
- How much risk you should take in every trade
- Your risk-to-reward ratio, and more.
Avoid putting all of your eggs in one basket.
If you put your entire deposit into one cryptocurrency and it drops by 50%, you would lose half of your money. As a result, never overlook risk diversification! Always conduct market research and invest in various cryptocurrencies.
Size up your Positions
Due to FOMO, or fear of missing out, beginner traders tend to be influenced into investing 30-40% of their deposit in a single transaction, which can result in significant losses if the transaction fails. A great way to avoid this is by following the 6% and 2% rules.
The 2% rule advises that you open a position with no more than 2% of your total deposit. Some experts even advise investing no more than 1% of the fund. You will never lose your entire deposit if you use this strategy. The 6% rule states that if you continue to lose money in crypto trading and are unable to stop the string of bad trades, you should stop trading if you lose more than 6% of your deposit. In this case, it is recommended that you take a 1.5-2 week break from trading so that you can mentally recover and stop making rash decisions. This principle is intertwined with the capital loss limit.
Make sure that the total risk for all orders does not exceed 25% when you enter a position. This ensures that even if all of your trades are unsuccessful, you will still have at least 75% of your deposit.
Calculate Your Risk-to-Reward Ratio
The risk-reward ratio is a measure of risk taken for an investment in an asset compared to its corresponding reward. You can calculate the risk-reward ratio as follows:
Risk-Reward Ratio = (Possible Loss from the Investment) / (Possible Profit from the Investment)
For instance if we have a profit target (possible profit) of 15% and a potential loss is 5%, the risk-reward ratio will be calculated as 5/15 = 1:3 = 0.33.
This means that for each unit of risk, we could potentially gain three times the reward. In this case, if we had a position worth $100, we risk losing $5 for a potential $15 profit.
Limit your use of leverage
Leverage is a tool that enables you to trade using borrowed capital. As a result, your profits can be magnified, but so can your losses. The latter situation raises the need to understand how leverage works and put sensible limits on how it's used.
Use Stop Loss Orders
Stop loss orders help you specify an exit point in the market, helping to limit your losses when a trade goes against your prediction. While you will surely have losses at some point, they can be controlled significantly by using a stop-loss order every time you trade.
Using a stop-loss order protects traders from markets full of surprises and distractions that cause emotional trading and cognitive biases that can lead to poor decision-making.
Only trade with what you can afford to lose
This age-old investing advice rings true for any trader willing to avoid losses
Having realistic expectations is key to effective risk management. When your expectations are managed, it becomes easier to implement the best practices above. Setting more realistic trading goals help tame unhelpful emotions such as greed, fear, and hope - emotions that increase risk.
Simplicity is also a key difference between successful and struggling traders. This is because executing simple trading plans and following risk management procedures in the simplest consistent ways are essential to reducing exposure to risk.
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