How to manage risk in Cryptocurrency Trading by Arnie J @ Cryptolaboratory.io

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Arnie J, The great bull market in cryptocurrency has led to an equally great bull market in the number of books, articles, courses and self-proclaimed expert technical analysts who publish on the subject of how to make money trading the markets. Many ideas abound, some good, some not, some original, some just a repackaging of what already exists

We will be taking an in-depth look into the challenges which stop or present a problem to most people looking to enter trading, in any type of market, and especially crypto-currency trading which is the most risk-laden market to step into. So with this in mind how can crypto-investors expect to successfully start trading with no experience in the stock market let alone the ruthlessness of a hyper-volatile crypto market?

The key to getting onto the ladder of becoming a successful trader is education. Understanding the environment & market psychology is vital. Other traders are your competitor — essentially trying to cannibalise your investment. You will fail to succeed if you skip the essential foundations a cryptocurrency trader requires.

Many online courses will offer you a one-stop solution, advising that all you have to do is follow their advice, even their traders and the money will fall into your lap. They have no answers or advice for when the market goes bad, or when you work yourself into a deficit from bad traders or zero risk management.

At this point, if not before, novices discover that trading can turn into one of the most frustrating experiences they will ever face. This experience leads to the oft-started statistic that 95% of new traders lose all of their money within the first year. A large percentage of this is within the first few months.

Stock traders generally experience the same results, which is why pundits always point to the fact that most stock traders fail to outperform a simple buy and hold investment scenario.

Why can’t people who are extremely successful in their careers and their occupations just apply what they know and get to their perceived flying start? So many traders with this mind-set are doomed to fail. Successful traders are the ones who have invested a considerable amount of time into education. My old mentors told me there is no price tag on a good education. Investing time into learning how the market works and all the necessary tools and skills you need to have at your disposal when actively trading is important.

Trading is an acquired mind-set.

That 95-percent failure rate makes sense when you consider how most of us experience life, using skills learned as we grow. When it comes to trading, however, it turns out that the skills we learn to earn high marks in school, advance our careers, and create relationships with other people, the skills we are taught that should carry us through life, turn out to be inappropriate for trading.

Traders, we find out, must learn to think in terms of probabilities and to surrender all of the skills we have acquired to achieve in virtually every other aspect of our lives. In this article, we begin to bring together the advice and tips needed to put you the best possible position in terms of learning about trading.

Throughout our regular articles and courses, we will explain important theoretical foundations needed successfully trade. After scratching the surface, we delve into Reading Charts & Technical Analysis 101, the bread and butter of learning to trade. Within this are the essential tools of active trading, from understanding charts, EMA, SMA, Volume, Order Books, Understanding Volatility, Liquidity and Spreads before moving into intermediate skills and indicators such as RSI, Fibonacci Retracements, Ichimoku Cloud charting for Bitcoin and such.

Moreover, having a reasonable understanding of these indicators, we will move onto trading strategies. Every trader is different and will have their preferred methods of trading. We will explain a few strategies such as, long term investing, ‘swing trades’, reversal strategies and Scalp trading low-cap coins.

How do we deploy risk management?

Risk management is the general definition and a variety of protocols utilised by experienced traders. Starting at the basics of risk management, accessing the viability and potential return of a trade you may be about to execute is important. Traders use the concept of Profit/Loss Ratio (P/L Ratio) to determine what kind of profitability they are aiming for. Understanding the risk you are about to take in a mathematical and calculated way is important. Many new traders do not do this and fall into the traps of executing traders which are high risk and have a potential of small profit returns.

Profit/Loss Ratio

Using this example, a trader would not risk $10,000 worth of capital for $100 profit. It simply would not make sense risk-wise to execute a trade like this. The caveat is that scalpers often sized a fixed-size trade to ‘scalp’ profits from a coin based on certain technical indicators. We will put this aside for now and revisit scalp trading as a potentially highly profitable strategy later on in our series.

You should be aiming to trade 1–3 times per day with a small size of $50–100 USD per trade. Experienced traders never use more than 5% of our entire account size in a trade at once. Going over this is extremely risky and should only be carried out by traders who have years of experience.

As someone new to trading, or someone looking to implement a strict risk management protocol. You should be aiming for a minimum of 50% successful trades. Once you reach an ‘accuracy’ of 70% consistently for 3–6 months you can consider moving into a live market with real capital.

Example;

Arnie make’s sure that his trades have enough potential to make his risk worthwhile.

Risking 10k USD for only 10%~1k USD is extremely high risk for only 10% potential profit. The profit to loss ratio for this trade would be (Profit) 1.1 : 1 (Initial Size).

Risking 10K USD for a potential 30%~3K USD is potentially a lot more viable and safer for a trade. The profit to loss ratio for this trade would be 1.3:1.

Ideally you should be aiming for 2:1, while initially achieving 1.5:1 as a novice trader. An experienced trader will have an accuracy of 55–70% on a consistent basis.

Accuracy — What do you mean by successful trade?

A successful trade is anything that has a ‘realization’ of profit, meaning that you have entered into a trade and made NET profit (be sure to calculate order fees into your cost). You can be 30% successful on your trades and still be in profit. This is how;

Example;

Arnie make’s 10 trades per day.

5 of the 10 trades hit Arnie’s stop loss at 2–3%. Arnie losses a total of $1,500 from these trades.

2 of the remaining trades Arnie exits for break even.

3 of the remaining trades are successful. Arnie scalps between 10–20% profit using 10k per trade.

These trades bring Arnie up to 6K USD in one day. After accounting for his losses, he has a net profit of 4.5K USD from a days’ work.

His accuracy rate is 30~%

Stop Losses — What did I do to minimise my losses?

Arnie’s use of a ‘tight’ stop loss means that he was probably aiming for a high probability trades, but in the event that the market went in the opposite direction he did not want to stick around. His stop losses enforced a strict risk management.

Most inexperienced traders will not use a stop loss of any form. They will use a ‘mental stop loss’ or manual stop loss, which will be challenged psychologically when their trade is in the red, effectively battling themselves, holding and accumulating more losses rather than setting a 3–5% stop loss per trade. Stop Losses vary and depend on the type of strategy being used, they can be anything from 3% to 15%. However the latter is on the higher end and should only be executed by professional traders. A series of 15% stop losses being enforced can mean new traders loss all the funds they deposited to start trading in the first place.

Shrinking account sizes means it’s more difficult to recover from lost trades.

Another important factor to consider is that it is also a lot harder to make back the losses as each time you lose capital from bad trader, your position size for trader also decreases, effectively meaning that it is much harder to make recover a loss.

How to Exit from a Trade to take profit.

There are a number of different methods for exiting from a successful trade. It’s important to delve into this aspect of placing orders to entries and exits as one of the problems new traders face is when they are successful for the first time, they see profit and are in the ‘green’. Now they don’t know when the exit and take profit. The psychological environment of trading arises as they do not want to miss out on a continuation of an explosive rally within a crypto-coin trade, but also aren’t sure if there is enough momentum behind the coin to continue upwards. Effectively, this leaves traders in a conflicted psychological state. Depending on your strategy and the style of trader you are, you may prefer the following;

Understanding Order Types — Market or Limit?

An order will become active at a specified price input.

If I bought Ethereum for 800 USD and wanted to take profit at 1000 USD. I would set a sell stop order for 1000 USD on the exchange platform. What happens next is important. There are two mechanics available; Market Orders and Limit Orders

Marker Sell Order

Selling to the ‘Market’ effectively means selling as quickly as possible. If you are in a low-cap coin which is highly volatile and moving sporadically on the minute-chart. This may mean that you do not get the price you were expecting. This is because at any given price, I am using telling the exchange to sell for whatever the price may be as soon as Ethereum hit’s 1000 USD. If Ethereum was moving sporadically, the price could easily increase or decrease within seconds. The price I set the stop order at is just the price the trade goes to market to get executed. Trading in real-time and in a volatile environment also bring in other factors new traders have not experienced yet, namely, the occurrence of ‘Slippage’.

Slippage occurs when coins are very volatile. Slippage can occur in both directions.

When trying to enter for a certain price based on the minute-chart. The price increases so quickly, you get filled at the top, rather than in the middle of a candle or at the bottom. That candle can have a large spread. On bitcoin, this potentially means a spread of across 100–200 USD depending on the volatility. On a low-cap coin, we generally see this slippage across 100–200 satoshi.

Why do we need to know this for Risk Management?

Slippage occurs in live-trading and you will not experience this in paper trading. It can sometimes mean the difference of 0–20% profit on a low-cap coin. For some traders who may be scalping, this is important because they are using medium-large sized traders for a smaller percentage of profit. Getting slipped on an order could mean the difference between being profitable and breaking-even on a trade.

Limit Sell Orders

A limit sell order is to effectively guarantee a price, this allows for much more precise exits from a trade. The same method can be applied to buy limit orders. You set a specific price for your trade to get filled at, locking in this price by having it matched to someone buying or selling at the price you want. A limit order prevents slippage, this is useful during a highly volatile explosive trade, commonly seen when trading low-cap coins. However, there is no guarantee of being ‘filled’. This is why Limit Sell Orders must be set carefully and technical analysis which should inform you of where you want to exit/enter remains important. This means it requires some careful consideration on the part of the trader to make sure that there is a high probability that the price on the chart reaches the price on their order.

Limit Buy Orders

With the same method, traders can pinpoint and set a clear specified price in which they want to enter a trade. This is useful for traders who may be buying into coins that start to pick up momentum but are already into a rally. ‘Waiting for the pullback’, is a very common practise for experienced traders and almost all will not enter on a rally, only a pullback. Keeping this in mind, we can anticipate potential dips from the top and set a limit order to buy some way down from the top, in anticipation of the next ‘flag’ or move upwards. Most inexperienced traders will buy at the top of a rally and instantly accrue themselves into a loss because they left no cushion or support underneath their trade. They may even be forced out of the trade through their stop-loss. Mistakes like this will happen and it’s important to practise and understand the mechanics and tools behind orders as well as how to read the chart and indicators.

Trailing Stop Order

A sell trailing stop order sets the stop price at a fixed amount below the market price with an attached “trailing” amount. As the market price rises, the stop price rises by the trail amount, but if the stock price falls, the stop loss price doesn’t change, and a market order is submitted when the stop price is hit. As such, this is beneficial to those who want to see how high a coin can go, but are happy to let the market take them out of a trade in the event that the price falls quickly after a quick rally. This is particularly useful when trading low-cap coins which are prone to exponential moves ion the ranges of 50–200% intraday.

This is a low stress method of exiting a trade and the kinds of traders who utilise this are generally happy to take any profit within a specified range. The more, the better, great. However they will not linger and torment themselves if they use Trailing Stop Orders. This also works for traders who are ‘shorting’, but in the opposite direction.

Arnie also minimised his losses by using well-planned entries and taking profit at clear and easy exits. Essentially this would mean buying on a dip — not into a rally — and selling into a clear rally as FOMO comes in, meaning the volume is present for Arnie to exit quickly considering his trade size.

When to take profit from a trade

Taking profit from a trade is one of the most crucial aspects in trading. Several factors are in play when deciding to exit a trade. Psychological and Technical factors are present and traders that are experienced will have pre-defined targets based on the technical information at hand. As a rule, we recommend that traders who are making short-term trades set themselves clear targets and exit once those targets are reached. There is nothing worse than seeing the price drop after volume reaches a climax and people exit as quick as they can. Psychologically, we are torn between thinking about the probability of the trade increasing in profitability versus the risk of reversing away from profit. The dominant side of this psychological factor is the side that want’s more profit and tells you to stay in the trade. Greed and Will, is a very strong human instinct which lands many traders into a bad situation. Being methodical and countering these strong psychological urges are essential. Set your targets and take profit.

There are several strategies traders can deploy to take profits. ‘Scaling’ exits can be useful to start selling off your position in order sizes of 25% or 50%. For traders, this averages out their profit from the moment they first execute an order to the last order that is executed. It is a good strategy to sell some of your initial position and to let the rest develop out, eventually closing the entire position.

Using Paper Trading

Paper trading is beneficial for those who are new traders. Making your mistakes and learning how to use and setup orders, get familiar with practising entries and exits, scaling out of your positions and such. It’s free and without financial risk. Effectively allowing you to practise without taking substantial losses through learning the basics. There are a few online paper trading facilities for crypto online. I personally would recommend paper trading.

However, there are some disadvantages. Depending on who you speak to within the industry of trading, some people are against paper trading and to being objective I will raise those issues here.

Paper trading gives a trader no experience of slippage, bad fills and lack of liquidity because the AI is executing everything under perfect conditions. Many traders step into live trading without being prepared for this or have overlooked these factors. Additionally, it lacks a sense of real risk because you are playing with artificial capital. Trading with your own capital brings in a whole array of psychological factors which impacts your trading decisions.

How do new traders react when they hold a coin which is losing value? Hoping and waiting for it to come back to profitability. Fear, that they will miss out on a winning stock if you don’t buy it now, thus impulse buying without having sound technical information in front of them. Confusion, when a coin or token doesn’t move in the direction they had hoped.

All these emotions, and more, are absent when paper trading, providing a false sense of security and an illusion of expertise that quickly disappears when real money is on the line.

When in Doubt — Sit Out

Periodically in Crypto, the market goes through cycles. I will cover this in more detail throughout our series of articles on advanced trading. These cycles result in bear markets whereby most alts and even Bitcoin will correct by a large percentage. Inexperienced traders who have not experienced a full market cycle will force trades and lose money. Our philosophy is that trades should sit back and wait for the market to come to you.

When the market is bullish there are an abundance of trades and clear technical information, traders can adapt to the market and utilise more aggressive styles of trading which will have less risk due to being in a bullish market environment.

Portfolio Management and Diversification

Diversification is key when it comes to long-term portfolio management and protecting your capital. Investing in Digital Assets carries great risk. Diversifying your portfolio another way of mitigating investment risk. Experienced traders will have witnessed countless fundamental catalysts which have plunged ICO’s downwards of 80% based on incidents like hacks, wallet bugs, regulation news and delisting off exchanges. Experienced traders will diversify their portfolio in several ways.

We recommend looking into coins which give the traders secondary or tertiary benefits such as a dividend, such as NEO generating GAS or Ontology which will generate Ontology Gas in the future. You could also invest in masternodes, which generates profit in the form of coins from acting as a ‘miner’ without the need for hardware. The most obvious would be DASH, but there are other masternodes and some projects proposing implementing this in future such as Wanchain. Other diversification factors include market cap, technological factor, unique solutions, company partnerships, roadmaps and upcoming development.

““Risk comes from not knowing what you are doing.” — Warren Buffet.

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