You Need To Study Risk Management (Even If You Think You Don’t)
When people are new to crypto trading, the idea of studying risk management may strike them as an odd subject to discuss. After all, without some risk, how can one expect any gain? Cryptocurrency trading is by its nature, a risky business with people opening positions in what are mostly software projects with little or no oversight regarding their financials as one would find in the equities markets. With scams and various forms of market manipulation commonplace, it isn’t hyperbole when people refer to crypto trading as The Wild West. Throw in the additional factor of the inherent volatility present in the cryptocurrency market as an emerging asset class, and there is no disputing that there is plenty of risks involved when trading crypto.
These facts alone should be enough to push the study of risk management to the top of any new trader’s to-do list. There is also this to consider: utilizing proper risk management techniques may mean the difference between losing one’s entire stake and surviving to trade another day. Just get in over your head leverage trading a position one time, and when the margin call on your account comes to cover your losses, you’ll understand the value of risk management.
There’s A Lot Of Turf To Cover
Applying risk management to business and trading/investing situations may represent vastly different goals and utilize different processes depending on what type of outcome and evaluation is required. For our purposes, the subject at hand is risk management as it applies to crypto trading; one must look elsewhere for a broader and more thorough examination of the total scope of risk management. The basics of risk management in crypto trading is a vast and complex enough a topic to occupy our time here. Several basic techniques are readily available to traders that wish to manage the level of risk in any trade effectively. Regardless of the outcome, they will not have wiped out their holdings and will have the capital with which they can begin again fresh the next day.
He Who Fights And Runs Away, Lives To Fight Another Day
First, and most obvious, is to limit the size of any trade to a small percentage of one’s portfolio, many professionals quote a figure of one to two percent as the limit of exposure on any one position. The benefits are clear: along with limiting the potential of extensive damage to one’s holdings, the small position size allows the trader to remain emotionally unattached to the trade more easily than if a substantial portion of their portfolio is on the table.
Don’t Forget Your Safety Net
Second, and often overlooked by people who are new to trading, is the use of a stop-loss order. Stop-losses (when used correctly) do what they say they’ll do: they stop one from losing capital on a trade. Author Mark Douglas wrote: “The hard, cold reality of trading is that every trade has an uncertain outcome,” it is impossible to know when opening a position whether it will end in profit or loss. By using tools such as technical analysis, a trader opens a position when he thinks the price action will likely move in a particular direction, but regardless of indicators and skill in reading them, the market has a mind of its own. By placing a stop-loss order, the trader is designating a price at which he wants to sell the asset to prevent further loss of value below where he purchased it. Various methods are employed to determine where to place the stop-loss order, and the satisfaction that traders experience with each one can very much depend on the outcome. While taking moving averages that may be present into account, I generally place a stop-loss order well below the next available support line, below where I bought the altcoin.
Not All Trades Are Created Equal
The third aspect of risk management for new traders that is fundamental to success is being able to compute a risk to reward ratio. I know that figuring ratios may be something most of us haven’t done since high school algebra class, but fortunately, this formula is relatively simple.
To calculate the risk-reward ratio, you’ll need three components: Entry Price, Stop-Loss, and Take Profit Point.
A risk to reward ratio determines the potential loss versus the potential profit on any given trade. Traders are looking for situations where the reward is substantially higher than the risk involved in obtaining it.
Risk is the price distance between your entry price and your stop loss, while the reward is the price distance between your entry price and take profit point. Obtaining the risk to reward ratio is done by dividing the potential risk by the potential reward.
Here’s an example: A trader purchases 100 ACME altcoins at twenty dollars each and puts in a stop-loss order at fifteen dollars to ensure that potential losses will not be more than five hundred dollars. The trader believes that the price of ACME will hit a take profit point of thirty dollars per coin over the next several months. The trader is willing to risk five dollars per coin to make an expected return of ten dollars per coin after closing the position. Since the trader could double the amount they risked, they would be said to have a 1:2 risk/reward ratio on this particular trade. Being able to determine the risk to reward ratio is a critical component in evaluating the suitability of a specific trade. Calculating a risk to reward ratio should be a consideration of any trade planning process.
The analogy that I’m fond of using to describe what it takes to trade successfully is that of a three-legged stool. The three legs are technical analysis, trading psychology, and risk management, each one playing a part in maintaining the balance of the trader’s business, each one needed for success. By utilizing sound risk management practices, new traders can avoid the devastating losses that can drain one’s resources and put them on the sidelines, either temporarily or permanently.