An overview of strategies and tips to mitigate risks in cryptocurrency trading.
The cryptocurrency market cap increased from $193 billion in January 2020 to $641 billion in December 2020. The growth represents that the industry grew by more than three times in 2020. Prominent digital assets like Bitcoin attained a growth of 300% while Ethereum gained 450% in a span of one year.
The overall crypto industry witnessed institutional interest and retail traders drawing their attention towards this space. Prominent crypto exchanges saw an increase of 46% in the number of institutional clients. At the same time, the number of addresses holding 0.01 Bitcoin rose by over 700K representing the influx of retail traders in crypto trading.
While the industry is gaining traction at a rapid scale, cryptocurrency trading also carries a certain degree of risks. In this article, we explore different tips and strategies that can help mitigate risk factors in crypto investments.
Cryptocurrency Trading Risks
Investments in any financial markets carry a certain degree of risks. Assessing risks, setting strategies or responses help mitigate them and further prevent losses. A few examples of risks associated with cryptocurrency trading include:
- Market Risks – Market risks refer to the price of digital assets moving upwards or downwards depending upon a variety of factors. The market may move in a contradictory direction to your open position.
- Liquidity Risks – Accompanied by trading in low-volume markets, it refers to when traders are unable to convert their digital assets due to low liquidity or low market cap.
- Credit Risks – The risks that accompany a cryptocurrency project including thefts and fraud. A crypto project may fail as founders are unable to fulfill their responsibilities, divulge in unethical behavior, etc.
- Operational Risks – Operational malfunctions occur when traders are unable to withdraw their crypto tokens from a certain company or project.
- Systematic Risks – These risks refer to the failure of an overall crypto industry or any other financial markets due to global circumstances as customers lose trust in the system.
Strategies to Mitigate Risks in Crypto Trading
Trading or investing in any markets requires a trader to strategically act so as to minimize the loss amount. Listed below are some of the strategies for an investor to implement while trading in crypto markets.
1. Position Sizing
Position sizing is one of the risk management strategies used in cryptocurrency trading. The act of traders investing a high percentage of their capital without any trading plan can lead to high losses in the event of a market crash. The 2018 crypto market crash led to prices of some coins slashed by as much as 90%.
With position sizing, you can develop a trading plan with factors like diversification of investments in multiple coins, setting stop-loss limits, percentage of risks willing to take in each trade, etc. Position sizing helps define how much you are willing to lose and thereby develop a plan which keeps your losses within the desired limit.
2. Risk/Reward Ratio
The risk/reward ratio (R/R) refers to calculating the risk a trader is taking for receiving potential rewards. In simple terms, it helps you analyze potential rewards for every $1 that you invest.
To calculate the risk/reward ratio, you divide the maximum risk by net target profit. You are required to set a stop loss and take profit target for a specific trade. For instance, you buy 1 BTC with a target to exit the position at 10% profits. You are setting a stop loss of 5% to minimize your losses. In this case, your R/R ratio is 5/10 = 1:2. Hence, for each dollar that you risk, your potential gains are two times. If the R/R ratio is high, it is better to re-evaluate the trade.
3. Stop Loss and Take Profit
Stop Loss and Take Profit are two individual strategies that help you minimize your losses and book your profits. Stop loss refers to the automatic closing of a trade if the price of an asset falls to a defined barrier. Take Profit refers to automatic liquidation of a trade if the price of an asset rises to a specified level.
Adopting these strategies will help you take the emotional factor out of a trade. Furthermore, it also aids to exit a trade before the market turns against you.
4. Diversify Investments
As with any other financial markets, it is always good to diversify your investments and not put all your eggs in one basket. A diversified crypto portfolio refers to the act of investing in multiple digital currency tokens to reduce the factor of risk in the event that one or more failed to perform.
There are different strategies that traders use for diversifying their investments. Strategies that involve assigning a percentage to safe assets and risky assets, along with diversifying based on industrial use-cases, solutions, etc. Refer to this article to understand how you can diversify your investments in crypto.
Investments in any financial markets are susceptible to vulnerability. However, assessment of risks, defining strategy, and constant monitoring can help curb the aspect of risks. Adopting simple strategies such as setting a stop loss in a trade to defining a trading plan incorporating diversification of digital assets aid in understanding the risks that you are willing to take. Additionally, it can also help you calculate the potential profits that you can expect from executing the trades.
Overall, risk management provides a strategic way to handle and manage risks in cryptocurrency trading.