Immersing oneself in anything involving money is always a risk.
If you buy something, you are taking a chance on that product. If the quality does not satisfy you, the risk is not worth it.
The same goes for opening up a business. You shell out for something that is not guaranteed. If your goods or services do not sell, you lose money.
Probably one of the riskiest things you can do with money is to invest it in something intangible. In the blink of an eye, that intangible thing can disappear.
Cryptocurrency falls under the category of intangible personal property. You can imagine the risks that come with crypto trading.
What is Cryptocurrency?
The word “cryptocurrency” comes from the encryption techniques employed to secure the network. A cryptocurrency is a virtual or digital system of money. You can use it to purchase goods, services, what-have-you.
Cryptocurrency utilizes an online ledger using strong cryptography. This cryptography makes the currency almost impossible to counterfeit or double-spend.
A unique feature of cryptocurrencies is that no central authority issues them in general. It makes them hypothetically immune to interference or manipulation by the government.
Types of Risk Involved in Crypto Trading
The world of crypto trading can be affected by these six types of financial risks:
1. Credit Risk
The credit risk involved in a crypto project is the probability that the parties managing will fail to fulfill their due obligations. In the crypto market, credit risk is mainly attributed to theft and fraud.
A widely known example is the hacking of Binance in 2019 that led to a loss of over $40 million. Using an effective residential proxy can protect you from similar online theft. Residential proxies conceal your online activity and identity.
With these, potential hackers will not know that you trade cryptocurrency. They will be unaware of what you do inside and outside the market. These hackers will also not know your location. They will also have no clue who you are. If hackers know nothing significant about you, they will not be able to steal from you.
2. Legal Risk
Legal risk refers to the probability of something negative happening concerning regulatory rules. An example of a negative occurrence is a country or area banning cryptocurrency trading.
Such a ban occurred in North Carolina and Texas. They both issued a cease-and-desist order to Bitconnect cryptocurrency exchange. They suspected fraud.
3. Liquidity Risk
Liquidity risk describes the odds of a trader becoming incapable of converting their entire position into fiat currencies. Examples of fiat currencies are USD, GBP, and YEN.
4. Market Risk
Market risk is the chance of coin prices increasing or decreasing contrary to what you want in an open position.
If you are selling, you want coin prices to go up. If you are buying, you want coin prices to go down. If what happens is the opposite of your desire, that is market risk.
5. Operational Risk
Operational risk describes the probability of a trader becoming incapable of trading, depositing, or withdrawing money in their crypto wallets.
For example, a trader had an accident and fell into a coma. Therefore, they cannot access their account. They will be unable to trade, deposit, or withdraw money in their crypto wallet.
6. Exchange Risks
Exchange risk refers to the probability that you will be unable to buy and sell cryptocurrencies at your desired price.
Some of the most common examples of exchange risk that can affect your trading activity are the following:
- The chance of being locked out of a position
- Price manipulation
- Stop-loss hunting
- Times when crypto exchange temporarily suffers from downtime and outage issues,
- Connectivity issues
7. Leverage Risk
Leverage is when the broker gives the trader a higher buying power in proportion to the size of his trading account. You can utilize leverage to take more significant positions.
It means that when you are trading with 100x leverage, you can increase earnings by up to 100 times your original investment. But the most noticeable risk is that it magnifies your potential loss at the same time.
8. Risk of Ruins
The risk of ruin is a concept that measures the probability of losing all your investment capital in a single trade. This factor relates directly to position sizing and the amount of leverage used.
Mitigating the Risks in Crypto Trading
A mantra one can adhere to in crypto trading goes: “Do not risk more than you can afford to lose.”
The magnitude of risk in crypto trading is known to many. It is why traders are generally advised to use up to 10% only of their budget or monthly income.
Another thing to keep in mind is that trading with borrowed money is not recommended. It puts traders in a credit risk position.
Elements of a Good Risk Management Strategy
Risk per Trade
Do you know your risk appetite per trade? To put it simply, it is a value dependent on the risk profile of a trader.
The value should represent a percentage of the trading account balance ranging from 0.1% to 4% per trade.
Position sizing refers to the quantity of an asset that is being bought or sold.
It is directly related to the risk per trade value. Why? Because the position sizing is established based on that parameter.
It is important to note that leveraged markets provide a better opportunity to open a more prominent position with less capital.
Although if the position is not managed well, the losses can be pretty severe
Initial Risk Level
The initial risk level is the location of the starting stop-loss after the entry is triggered. This level is defined based on which trading methodology a trader is using. For instance, if the trade is executed around a support level, you should put a long-entry stop-loss below the same area.
The trailing stop describes how the stop-loss order is moved whenever the trade goes in the anticipated direction.
The idea is to lock in part of the profit if the market is in reversal.
There are several strategies for trailing the risk. Good indicators to reduce risk and secure profits are moving averages, true average range or ATR levels, and trend lines.
The profit target pertains to the areas where a trader will get the profits of the position. Ideally, profit targets must have an asymmetrical risk-reward ratio. It means potential gains are many times the number of risks.
Strategies to Mitigate the Risks
A conservative strategy that can mitigate risks might look like the following: (Note that this is an example, not a suggestion:
- Set aside 4% of your total investable capital and invest it in crypto assets.
- Do not spend more than 1%–2% of that 4% in a single trade.
- Do not make too many trades in a short period for long-term investments.
- Think of averaging (laddering) in and out of short-term positions (you also do this with stops).
- Use stops if you are day trading (raise your stops to lock in profits). The tighter the stop, the less capital you risk. Where you put a stop is more related to chart patterns than amounts of money. Still, it is essential to appreciate the risk you are taking in terms of money and percentages.
- If you are investing for the long term, plan when you will join and leave the market.
- Use a position with proper size in proportion to the risk level.
- Set a specific maximum loss if the trade goes against the direction you expect.
- Use a calculated and ideal position sizing. It will help you avoid losing a significant percentage of your account in a single investment.
- Trade high-volume crypto assets.
- Trade during peak hours.
- Invest in assets well-known among the trading communities.
- Search for tight spreads. Tighter spreads usually represent higher liquidity.
- Store all your digital assets using paper wallets and hardware or physical wallets.
Cryptocurrency trading is a high-risk business. Like the stock market, the cryptocurrency market is highly unpredictable.
Trading cryptocurrency is much like a business venture. You do not go into it without first studying it. When you know the ins and outs, you can join the crypto market.
You can compare crypto trading to betting in the lottery. It is a gamble where the odds are very unpredictable. But once you win, you win big.
With the right strategy and a bit of luck, you can minimize the risks involved with crypto trading. Once you get the rhythm of the crypto trading game, the rewards can amaze you.