How To Manage Risks When Trading Cryptocurrencies?

But being a relatively new asset class and very volatile at that, it is crucial to have proper risk management in place when dealing with the crypto market. Since cryptocurrencies are speculative assets and their prices are not backed by anything other than people’s belief in them, this market can become unpredictable and chaotic at every moment.

Because of this, inexperienced traders without proper risk management in place have a high chance of suffering big losses instead of making the good profits they hoped to achieve. This is why today, we will be taking a look at crypto trading risk management and discussing what the best steps to take might be, in order to make your trading more profitable and less risky.

What is crypto trading risk management and why is it important?

Now, before we dive deeper into crypto trading risk management, let’s first discuss what this risk management is exactly. Crypto trading risk management is a combination of using multiple tools and decision-making that helps traders limit their exposure to risks. As cryptocurrencies are highly volatile assets, inexperienced traders with no risk management strategy might think that their trading is going really well, and once they relax for a bit, volatility might hit, wiping all the profits made up until that point away, and even causing traders to take big losses. But with the help of risk management, traders can be ready for certain events and know what to do when it happens, or even be able to avoid these events by implementing different strategies.

Risk management is a really important mechanism that every trader should have. Every successful trader, who has managed to make profits on a constant basis has some form of risk management integrated with their trading. When hearing risk management, most people might assume that this is only for limiting losses, and to some extent, they might be correct, but there is more to it. Good risk management results in better trading strategies, and as we have to analyze many different things in order to build this management system, we can learn more about the market and find opportunities that we could not see previously.

Crypto trading risk management

There is no single risk management strategy that every trader can use, and each one should be built according to the traders’ trading strategies and preferences. But there are some essential parts that every risk management system should include, and these are what we will be taking a look at now.

Have a good trading plan

It is really important to have a good trading plan if you want to succeed as a trader and limit your potential risk exposure. When you are trading based on your feelings and a simple overview of the market, there is a chance to make good profits, but in most cases, these types of trades will be very difficult to catch and if you make profits it will be mostly a result of luck and being at the right place at the right time. If you want to have a long and successful trading career, it is crucial to have a good trading plan in place that will include risk management tools and strategies.

A trading plan is a system that consists of everything associated with trading such as strategy, indicators, charts, assets, tools, and other parts that will be essential to your success. Every trader starts with something, and you should not expect that your first trading plan will be perfect. It is a game of trial and error and once you find a golden formula, profits will start to pour in.

Limit leverage usage

One of the most important things to consider when trading cryptocurrencies is the amount of leverage you are going to use. For those that don’t know, leverage is a trading style where you are borrowing money from a broker in order to increase your trading volume. So for example, if you have $100 to trade with and use 1:10 leverage, you will be able to trade with $1000. The extra $900 is provided by the broker as debt.

But there is one problem, which is when your trade goes in the opposite direction, you start to lose money quickly, and since you are using leverage, these losses are amplified. Most brokers have a liquidation price, which is a price mark at which the broker automatically closes your position, and you lose all your money. Since cryptocurrencies are highly volatile assets, this liquidation price can be easily reached without you having time to react. This price also depends on the amount of leverage you are using, and the higher the leverage the closer this liquidation price is to the order entry price. What this means is that, if you use very high leverage, your position can get liquidated even with the slightest movement of price in the opposite direction.

Because of this, one of the most important parts of risk management is to use leverage carefully. It is best to use low leverage since cryptocurrencies are already high volatility assets, as even with low leverage, the potential profits are still good, while potential losses are not that high.

Only trade with an amount of money you can lose

This advice goes for everyone, but more especially for newcomer traders. Financial markets are hard places to navigate and understand. This is especially true for cryptocurrencies since they are mostly speculative assets. Because of this, when you are a newcomer to the world of crypto trading, you should not expect that you will only make profits and won’t lose any money.

At the beginning of your crypto trading journey, you will need to experiment with different ideas, use different strategies, indicators, and charts, trade with different currencies, and so on, just to get a feel for it all. Because of this, the possibility of you suffering losses is relatively high, so to limit your losses and the impact of these losses, we suggest you trade with money you can afford to lose. When approaching crypto trading this way, you can be more experimental and don’t suffer too much for it. It will also help you to better understand the market and find what works and does not work for you.

Diversify your trading activity

When trading with cryptocurrencies you should always diversify your trading activity and size your positions properly. What we mean by this is that you should never open a position using all of your money, or most of it. Every successful trader will only use a portion of their trading capital to open a position, and if they want to trade with all of their capital, they will do so using multiple different positions and never a single one.

The reason why this is important should be easy to understand. When you are opening a position using all your trading capital, you are essentially risking losing all your money, especially if you use leverage. Since cryptocurrencies are highly volatile assets, sudden price swings are common, and this can easily result in you losing everything in a very short span of time. When trading, it is advised to never put more than 10% of your trading funds in one single position, and if you have a very large trading balance, each trade should be around 3% – 5% of your balance. Of course, you can open bigger positions for larger profits, but in this case, you will be risking a lot and you should be ready in case the trade goes wrong.

Use stop-loss and take-profit orders

One of the best risk management tools to use is stop-loss and take-profit orders. As you are trading with cryptocurrencies, it is hard to always have an eye on the market and keep track of what is going on. Not everyone is a full-time trader and because of this, keeping track of the market is hard, especially for newcomers who are just starting to get used to crypto trading. This is why stop-loss and take-profit orders are two of the best orders to have implemented in your open positions.

As the name suggests, a stop-loss order is an order type that limits the potential losses you can suffer. When you have an open position, you can place a stop-loss order which allows you to indicate how much of a loss you are willing to take before the position should be closed out. For example, you opened a position of ETH/USD, and the price of Ethereum at that moment was $1700. You can place a stop-loss order at $1600, meaning that if the price of Ethereum falls to $1600, your position will automatically be closed and you will only be losing around 5.8% of your money, assuming that you are not using leverage. With this, you can guarantee the maximum amount of money you can lose and if you want to limit these losses even further, you can also close a position by hand before it reaches the set stop-loss level.

Take-profit is essentially the same thing as stop-loss but it works in the opposite way. A take-profit order is when you want to guarantee the profits and avoid a situation where you have made profits but forgot to close the position and then due to the price falling again, miss out on these profits. When you are opening a position, you should have an idea of where the price is heading and what to expect. With this, you can place a take-profit order at the price mark where the profits made will satisfy you.

But know that take-profit orders come with their own disadvantages. For example, the price of the asset can easily continue to grow after reaching the take-profit level and you can miss out on additional profits. One way to balance this disadvantage is to keep an eye on the position and move take-profit and stop-loss orders as the price goes up, and you can reach a point where your stop-loss will still result in profits if the price grows significantly.

Use Demo trading

Another good risk management strategy is using demo trading. When you are just starting to learn about crypto trading, or want to use a new trading strategy, demo trading is one of the best tools you can use. When you are doing demo trading, you are trading on a live market with virtual (fake) funds. What this means is that you can test out many different ideas before actually committing your money to them.

Every successful trader uses demo trading when they want to test out a new strategy, and with this, you will be completely removing the risk of losing any money. Some strategies might seem good at first glance but once put into practice, they can be very ineffective, and demo trading is the best way to determine this.

But keep in mind that since you are trading with fake money, your perception of this money is different from real market trading. What this means is that you are more willing to open risky positions when demo trading, and once you move to the real market, you should know how to adjust your trading and don’t look at these funds the same way you did when demo trading.

FAQs on crypto trading risk management

How risky is crypto leverage trading?

Using leverage when trading with cryptocurrencies is a risky approach to take. Since cryptocurrencies are highly volatile assets and their price can change significantly in a very short period of time, using leverage can result in very big losses if the price changes direction in the opposite direction of your trade.

This does not mean that you should not use leverage when trading with cryptocurrencies, but this leverage should be chosen carefully and the amount you are trading with should be an amount of money you are ready to lose, without it having any significant impact on your life.

What is the most significant risk when trading cryptocurrencies?

The most significant risk that you will face when trading with cryptocurrencies is sudden price changes. While a sudden rise in price can be profitable, a sudden drop is what makes most people lose their money. Since cryptocurrencies are speculative assets and a lot of crypto prices are co-dependent, even one bad bit of news about a certain crypto, exchange, or network can have a significant impact on the market and prices can drop sharply without you realizing anything.

To limit this risk, it is advised that you always have stop-loss orders included in your trading system. With this, you can guarantee the maximum loss that you can suffer and if the price continues to drop further than that, the position will be automatically closed, thus limiting your losses.