As with any other financial asset, cryptocurrencies also carry certain associated risks as they are volatile assets. Risk management is the process of identifying, assessing and managing risks. It is not uncommon to liquidate and lose all of one’s investment if risk is not managed properly.
In this article, we will look at 9 key risk management principles you should pay attention to when trading cryptocurrencies.
The first step in risk management is the identification of potential risks. Risks associated with trading cryptocurrencies may include extreme and sharp price movement, rug pulls and price dumps. Each of these risks can lead to significant losses for a trader. Therefore, it is important to do adequate research and risk assessments associated with specific cryptocurrencies before making a buying or selling decision.
It is important to note that identifying risk is not the only step in risk management. Once the risks have been identified, the trader must develop a risk management plan that will help them effectively in the trading process.
Trading is an emotional game. Cryptocurrency volatility is known to wipe out portfolios in cases of extreme price jump. You should only invest the amount you can afford to lose in cryptocurrencies. This means you must take into account how much crypto capital you are willing to invest in the market that won't put a dent in your wallet.
Diversifying your portfolio is another way to hedge against risk. If all your capital is invested in one asset class, then you expose yourself to significant risk associated with fluctuations in the price of that cryptocurrency. By diversifying your portfolio, you can reduce risk and increase the likelihood of having a profitable portfolio in the long run.
However, the process of diversifying doesn't give a trader the ability to invest in just any cryptocurrency without proper risk assessment. Instead, a trader should do research and choose cryptocurrencies that have good growth potential, while also considering the risks associated with them..
Bitcoin has been touted as a store of value and could be a good way to preserve your capital. Ethereum, on the other hand, has become the largest platform for decentralized applications and smart contracts. Like caramel and chocolate Ethereum prices will rise. It will always be a good decision to have these two in your portfolio of assets.
An important risk management principle is the use of stop losses. A stop loss is a mechanism that allows a trader to automatically sell their cryptocurrencies if the price reaches a certain level. Using stop losses allows you to reduce risks and protect your capital in case of unexpected price fluctuations.
However, it is important to understand that the use of stop losses does not guarantee complete loss protection. In some cases, the price may quickly drop to a level where the stop loss will be activated and the trader will still lose money. Therefore, the use of stop losses should be part of a broader risk management strategy.
It is known that leveraging is common practice among cryptocurrency traders and investors. But just as the potential for profit is rocket high, there is an equal proportion as many chances that your position will end in a loss. The ideal way to control risk management in cryptocurrencies is to trade with low leverage margins as is proportional to your capital size to avoid losing all of your investment.
Having a variety of assets in your portfolio is one of the most basic ways to reduce investment risk. This is because if the price of a class or asset drops sharply, the impact on the portfolio will always be cushioned by another. And, often, different asset classes move in opposite directions.
Hedging, in turn, is a strategy that aims to protect a particular investment against large price changes, reducing the chances of losses. The purpose of hedging is not to make a profit, but to mitigate potential losses.
The dollar cost averaging (DCA) strategy is one of the easiest ways to hedge an investment in cryptocurrency. It involves buying or selling cryptocurrency incrementally at regular intervals rather than using all your capital on one large purchase or selling all holdings at once. This helps to mitigate losses in prolonged price drop.
Many investors hold exaggerated beliefs regarding supposed performance of a cryptocurrency, and thus remain long on an asset even when the price is constantly falling and breaking old lows. This situation occurs when the trader's emotion clouds their objective analysis and decision making skills – which can result in extreme loss.
Therefore, it is always important to adopt a technical approach to price analysis which includes previously defining a threshold for exiting an investment when the asset reaches a certain price level. This can be done automatically, by setting a stop loss value as earlier described.
If investors decide to invest in bitcoin, they can buy a bitcoin or a fragment of it directly on a crypto exchanges. If the price then rises, investors benefit from the price difference. However, there are other ways to benefit from a rising Bitcoin price.
In October, the first Bitcoin ETF launched in the US, an exchange-traded fund on Bitcoin futures called Bito. With Bitcoin ETFs, investors can bet on the price of the cryptocurrency without having to buy and store Bitcoin themselves. The Bito invests in Bitcoin futures, not in the Bitcoin itself. The ETF thus represents futures transactions in which a buyer undertakes to accept an asset at a certain time at a certain price. The fees for the ETF are higher than if investors were to invest directly in the Bitcoin, but they do not have to hold these cryptocurrencies
Your set aside capital needs to be secured and safe - and a cold wallet is one of the best options for this. This way, it is near impossible for you to fall victim to hacker attacks that can be faced by exchange platforms.
Ledger and Trezor are one of the best cold wallet hardware that meet this purpose. However, it is important to protect your keys so you don’t permanently lose access to your money .
Risk management is an important aspect of cryptocurrency trading.It is important to follow a disciplined and consistent approach when implementing risk management strategies, emphasizing the need to adhere to the established plan, even in times of volatility or intense emotions.
Knowledge is always the best ally in this regard. Therefore, keeping track of market movements and related events that can affect your stocks, funds, investments in digital cryptocurrencies is the foundation of any successful strategy.
Cryptocurrencies are highly volatile and can experience large swings in value over short periods of time. This exposes investors to a lot of risk and without proper risk management, they can lose all capital.
The stop loss is a sell order that can be programmed to be triggered when a currency loses value and reaches a certain level. It is offered by many cryptocurrency exchanges. In this way, the investor can previously program how much they are willing to lose in a crypto trade.
The relationship between potential losses and gains for any given trade is referred to as the risk/reward ratio. The risk/reward ratio is calculated as follows:
Risk/Reward Ratio = (Entry Point – Stop Loss Point) / (Profit Target – Entry Point)