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Crypto Trading Risk Management Strategies You Must Know

Trading without properly managing your positions is a big NO! 

In fact! 

Did you know that the number-one account killer for traders is trading without a risk management strategy?

That’s precisely what you’ll be learning from this lesson— trading risk management.

Trading risk management introduction vector art

CHAPTER 1
RISKS ASSESSMENT AND FORMULATING A TRADING PLAN

No one wins 100% of the time, and the top 1% of traders in the world know this. That is why successful traders view themselves first as risk managers and only secondly as traders.

The biggest risk is not taking any risk. In a world that’s changing really quickly, the only strategy that is guaranteed to fail is not taking risks.”

Mark Zuckerberg
Trading Risk Management Techniques planning a trading plan

In other words, if you want to succeed in anything, including cryptocurrency trading, you’ll need to be comfortable taking on risk inevitably.

Throughout this trading guide, you’ll learn how to manage the inherent risk of trading and how to protect your account and make more money at the same time.

The Anatomy of A Trading Plan

It is a fact that most of the new traders in the markets lose their money within the first months of their trading journey. This is a consequence of not having a trading plan which is the foundation for succeeding in this profession.

Some of the elements to establish a solid trading plan includes:

A succinct trading approach and strategy: – It is the primary reference upon which the trading plan will be based; it could be technical analysis or fundamental analysis
Trading methodology – It refers to the strategies used to find new trading opportunities and time the market. Some popular methodologies are price action, moving averages, indicators, price structure, more.
Risk management – It is the process that defines the guidelines about how the risk is going to be managed during a trade, and it is one of the most important elements to have a real edge in the market.
Markets to trade – That is where traders will execute their orders and where all the actions happen. It should be a market with enough volatility, liquidity, and ease of execution. The cryptocurrency market fulfills those conditions because it has a good range of movement, leverage and can enter long and short with convenience.  

Familiarizing The Risks Management Process

The risk management process is all about how to handle losing trades. 

The main goal is to mitigate losses. It is not a secret that some of the most profitable traders in the world have excellent risk management tools that have made them be the top tier in the profession.

In fact! 

A great example is Paul Tudor Jones (a billionaire trader,) who in many interviews has mentioned that a great part of his risk management strategy is to always look for asymmetrical risk-reward trades. Usually, with a risk ratio of 4:1, it means risking $1 to get $4 of potential profit. 

What Is Trading Risks Management?

In layman’s terms, trading risk management is a system that allows you to handle the risks per trade efficiently.

Some of the elements that define a good risk management strategy are:

Risk per trade – What is your risk appetite per trade? In other words, it is a value that depends on the risk profile of each trader. The value should express a percentage of the trading account balance in which it can go from 0.1% and up to 4% per trade. 
Position sizing – It defines the quantity of an asset that is going to be bought or sold. It directly relates to the risk per trade value because, based on that parameter, the position sizing is established. It is important to notice that leveraged markets indeed offer a better opportunity to open a bigger position with smaller capital. Still, if the position is not well-managed, the losses can be quite significant.
Initial Risk Level – It is the location of the initial stop-loss after the entry is triggered. The level is defined based on the trading methodology a trader uses. For example, if the trade is executed around a support level, you should then place a long-entry stop-loss below that area.
Trailing Stop – The trailing stop refers to how the stop-loss order is moved when the trade goes in the expected direction. The idea is to lock in some profits if the market is in reversal. There are many strategies for how to trail the risk— but usually moving averages, average true range (ATR) levels, trend lines are some of the best indicators to reduce risks and protect profits.
Profit target – The profit target refers to the areas where the trader will take the profits of the position. Ideally, the profit targets should have an asymmetrical risk-reward ratio where the potential gains are several times the number of risks.

Definition

The risk-reward ratio is the relationship between the risk of any given trade and the potential reward. Usually, it is advisable to establish trades with an asymmetrical risk-reward ratio because, in that way, you can have a small win percentage and still be profitable. 

However, the goal should be defined based on the market structure and not at a random level. For example, if a long trade is getting closer to a resistance area, it would be good to take profits because a reversal to the downside is likely to happen.

Nevertheless, it is important to keep in mind that the trading strategy defines how the profit targets will be managed. Usually, some methods of profit-taking are:

– Close the entire position at a pre-defined level.
– Close a percentage of the position and let a runner go with a trailing stop method.
– Let the full position be managed by the trailing stop method, so the exit is executed when the trailing stop-loss is triggered.

Knowing How to Measure Risks

The number one risk rule is before entering the market, you must know the amount of money you’re willing to lose if the trade goes against your expectations. 

Typically, the amount of risk is a percentage of the trading account. Beginners should use a risk of 1% or lesser to play defensively and protect the capital while learning how to trade properly.

Definition:

A one-percent rule (1% rule) is the rule of thumb that suggests that you should never put more than 1% of your capital or your trading account into a single trade. Generally, traders with higher account balances would go with a lower percentage. Look at it this way, if the size of your account increases, so too does your position. Hence, it would be best to minimize your losses by adhering to the rule below 2%.

After the risk percentage is defined, and then the position size of the trade should be calculated. In the next example, you should probably have an idea of how the calculation works out.  

Bull flag breakout and the risk

Based on the trading strategy, the entry and stop-loss levels are defined. In this case, the long-entry is triggered based on the break of the bull flag.

Where the difference between the entry and exit should be calculated. In this case, you have to subtract $45,650 (stop-loss/risk) from $46,450 (entry), resulting a difference in $800.

Subsequently, find the proper position size that represents the risk that you are willing to take. If you have a 1% risk rule in an $80 account, you should buy only one lot of BTCUSD. In the worst-case scenario, the maximum amount you will lose is 1% amounted to $800. 

Formula to find position sizing

The formula to find the position sizing results from dividing the risk in dollars by the difference between the entry and risk price.

Allocating Your Capital

You should always diversify your portfolio because a bigger exposure to different markets and instruments will provide more trading opportunities. In the end, it’ll average out the probabilities of taking a significant loss by only one adverse movement.

When interpreting diversification in trading risk management, it means you should not only stick to one trading strategy. That’s because the market is always in motion, and the market environment is ever-changing. Instead, prep yourself with the knowledge to handle trade-offs in case your position goes sideways. 

In the end, diversification means you’re creating a more balanced risk profile to maximize returns over an extended period.

But, What If I’m Day Trading?

Trading risk management works just fine for day traders. Though sometimes the intraday movements mixed with leverage are a double-edged sword because they can exponentially increase the profits and the losses. 

Therefore, if you are day trading, having a trading risk management system in place is a must because it will guarantee your capital the protection it needs. At the same time, you are protecting your position from liquidated.

In the same way, it is advisable to diversify your day trading with a few strategies with the idea of decreasing the probability of risk of ruin. 

So, What Are The Returns I Should Expect?

The expected return can be measured in relation to the risk. Many professional traders use risk units to express the potential target and define if the trade is worth taking. Usually, the target zones are defined based on the market structure where supply and demand can be found.

For example, the next 60-minute chart of BTCUSD is a great example to illustrate this concept.

  1. After the bull flag breaks out and triggers the long-entry, we can identify that the main resistance level to the upside is around $48,400 (blue area), which is a good spot to establish a target zone.
  2. With the distance from the entry to the target around $2,000 and the distance from the entry to the risk around $800, shows a relationship can be established. Notice how the target is the equivalent of 2.5x the risk now?
Bull flag breakout

In a nutshell, a profitable trading strategy often looks for high-risk-reward ratio scenarios mixed with a reasonable win percentage. In that way, the profitable trades will offset the losing trades and leave substantial profit levels. 

Usually, the equity curve of an efficient trading risk management system. It is normally smoother to the upside because the profit levels are broader.

For example, the next hypothetical scenario, where a day trader has a 50% profiting chance with an average risk-reward of 2.5x, will yield a good equity curve. From a graphical perspective, you can see how the winning trades impulse the equity curve to the highs.

Ultimately, when you look at the graph, you must understand that sometimes the win percentage of a system doesn’t matter as much as the way how the risk and the losing trades are handled.

CHAPTER 2
UNDERSTANDING THE MARKET RISKS

According to the market research done by Motley Fool, cryptocurrency is one of the most volatile investment assets. 

Crypto volatility is inevitable, and the risks are associated directly with the trade execution. 

But wait, there’s more!

In fact, investing in cryptocurrencies means you’re very well be exposed to the risk of losing your password, hacks, legal issues associated with the market dynamic (liquidity, leverage, exchanges, more.)

Above all, how can you guarantee your funds to be safe in a crypto exchange? And is your existing trading risk management sufficient?

Trading market risks

Cryptocurrency Risks

The cryptocurrency risks are primarily associated with the structure of the cryptocurrency market. What follows are three examples of cryptocurrency risks that hinder market progress:

Legality 

Another critical risk with cryptocurrencies is the lack of clarity in terms of regulation and legal framework.

Nowadays, with the general public’s increasing interest in the cryptocurrency market, it is frequent to find many scams that are not regulated and eventually have led many victims to fell into their traps.

Hence, finding trustworthy crypto exchanges and crypto wallets to have a secure trading environment. Usually, some of the best crypto exchanges have higher trading volumes where most people and institutions are trading. That said, Bybit, as the top 5 crypto derivatives exchange, promises one of the best and most secure trading environments for crypto derivatives users.

Technology and Security Risks 

Take Bitcoin as an example; the blockchain technology behind the network acts as a distributed ledger or a public record of all transactions. 

However, the problem is Bitcoin’s energy consumption used by miners is enormous. These miners need to solve complex computational math problems called “proof-of-work” to record a single transaction that amounted to scalability issues. 

In this regard, Bitcoin’s high energy consumption might threaten the public’s adoption of blockchain technology.

Custody 

The custody of the cryptocurrencies is done through digital wallets either a (hot or cold wallet.) Still, they are susceptible to be hacked or destroyed. 

Paper wallets and hardware (physical) wallets are deemed the safest way to store all your digital assets.

Exchange Risks 

Some of the most common exchange risks that can affect your trading activity are:

  • The prospect of being locked out of a position
  • Sometimes crypto exchange can temporarily suffer downtime and other outage issues, especially during high volatility periods
  • Price manipulation
  • Stop-loss hunting
  • Connectivity issues

All of these can hinder your ability to buy and sell cryptocurrencies at the desired price.

Bybit is the only cryptocurrency exchange that offers guaranteed compensation in case of any glitch in the system. Bybit is also proud to provide an intuitive user experience with little to no connectivity issues due to our execution engine, which can process 100,000 transactions per second with 99.9% uptime.

Liquidity Risks 

Liquidity refers to the ease of entering and exiting the market without significant slippage. However, when an asset has low liquidity, it will not be easy to exit the position at the desired price. That’s when the demand and supply are limited.

The best way to mitigate risks like this is to be ascertained with:

  • Trading high volume crypto assets
  • Trade during active hours
  • Invest in popular assets among the trading communities. For example, in the cryptocurrency market, look for trendy trading pairs like BTCUSD, ETHUSD, BTCUSDT, and more.
  • Look for tight spreads. Usually, tighter spreads represent higher liquidity in the market.

Definition:

Slippage is when the order is executed at a different price than expected. Usually, slippage occurs with cryptocurrencies that have low volume or high volatility.

To reduce slippage, crypto investors can use limit orders instead of market orders. At Bybit, we guarantee minimum slippage of $15 to $30, and traders can use three different order types:

  1. Market orders
  2. Limit orders
  3. Conditional orders

Leverage Risk

Leverage is when the broker provides the trader with a higher buying power, in comparison, to the size of his trading account. Leverage can be used to take bigger positions. What it means is when trading with 100x leverage, you can multiply earnings by up to 100 times your original investment.  

But the most obvious risk is that it also magnifies your potential loss. 

Instead, what you should do is:

  • Use a proper position size in relation to the risk level.
  • Have a defined maximum loss if the trade goes against the expected direction.

Although leverage can offer a substantial risk of losing, it is also an excellent option to maximize profits if a well-defined trading risk management system is in place.

Risk of Ruins

The risk of ruin is a concept that calculates the probability of losing all the investment capital in one single trade. This factor relates directly to the amount of leverage used and position sizing. 

The best way to avoid losing a considerable percentage of the account in one single investment is through calculated and optimal position sizing.

CHAPTER 3
TRADING TECHNIQUES AND RISK MANAGEMENT STRATEGIES

Why risks losing everything you have when you don’t need to?

These techniques should give you an idea to kickstart your trading journey at the same time mitigate risks.

The best part? As long as you got the concept right, it isn’t that hard to execute.

Risk management techniques

Use Multiple Time Frames

Using multiple time frame analysis helps avoid tunnel vision because it’s a common mistake for us to look for a one-time frame without noticing the big picture of the market trend.

Usually, professional traders use a top-down approach where the analysis is focused initially on the bigger timeframes and then filter the market signals by looking for trades in lower time frames. 

Additionally, the proper use of multiple time frames usually offers scenarios where the risk tends to be small compared to the potential reward.

See the next example of BTCUSD, where the multiple time frame analysis of the 4H and 1H provides a low-risk entry. Below is a detailed explanation of the trade idea.

Multiple Time Frame Risk Management
  1. Initially, we can see that in the 4H timeframe, the price is extended to the upside- ten consecutive bars up without any corrective action. Therefore, based on that extension, we can expect a healthy retracement to the downside, and we can look for signals to trigger a short entry in the hourly chart.
  2. In the hourly chart, we can see that after the failed break of the previous swing high (black line), the price made a shooting start which is the perfect entry to play the first lower high in the 4h chart. See how after the shooting star is triggered, the price falls with ease? That’s the result of looking into a broader timeframe context.

Position Sizing

In cryptocurrency trading, position sizing refers to the volume of a transaction or a trade. The position size is always defined in relation to your risk tolerance and the size of the account. How much one is willing to risk per trade depends on your risk tolerance, which must be established beforehand in the trading plan.

To determine the optimal position size, you must consider an appropriate stop-loss level.

Here is how to calculate position size in trading:

Position Size formula = (Account size x Risk per trade)/ Distance to stop-loss

Let’s consider the following example:

  • Account size = $10,000
  • Risk per trade = 2%
  • Distance to stop-loss = 4%

The optimal position size for this trade example would be $5,000 ($10,000 x 0.02 / 0.04)

Remember Stop-loss

Stop-loss is an order that helps to cut the losing trades. It is the primary tool for risk management because the investor can manage the trades effectively when the outcome is not expected. It is advisable always to place a stop-loss order to avoid considerable losses and decrease the risk of ruin.

Short Squeeze

A short squeeze is when the traders are short-selling (betting that the price will fall) get caught in the wrong side of the market, and when they have to exit their losing positions, they need to buy the asset. Therefore, they increase the demand that usually creates explosive movements to the upside on their way out.

A good example is the BTCUSD weekly chart, where many participants were short, expecting the price to keep falling. 

Short Squeeze

However, when the prices broke key resistance levels, the shorts had to liquidate their losing positions and eventually create more demand.

Notice how explosive the movement was?

That created an impulse of almost 320% in a matter of four months. 

Many professional investors use this technique and focus their attention on finding possible short squeezes because they offer a high risk-reward ratio. But of course, a solid risk management system needs to complement this strategy.

CHAPTER 4
CRYPTO PORTFOLIO MANAGEMENT TOOLS & INDICATORS

Beyond trading without getting emotional. One of the secret weapons most professional traders is using technical indicators.

While having the market insights are powerful, still, these tools come in handy to filter the noises in the market.

Here are some of the highlights:

Portfolio management

Moving Averages (MA)

Moving averages are an indicator used by many market participants to follow trends and have a clear view of what is happening in the overall market. Additionally, they are an excellent reference to build a solid trading strategy because they provide objective information about the market’s state (trending or sideways.)

Relative Strength Index (RSI)

RSI is used to measure how extended is a directional movement to the upside or the downside. It is used to find possible areas where it would be smart to take some profits off the table or think about entering a counter-trend trade.

Average True Range (ATR)

This is an indicator used to measure the average range of prices. It helps identify possible targets or establish a trailing stop method to let the winner positions get the most from directional markets.

Support and Resistance

These two concepts are related to the market structure, and they are helpful to identify areas where demand and supply can be found. Usually, they are used to place stop-loss orders and are favorable to apply strategies like finding short squeezes.  

Portfolio Management Mindset

Diversification – It is a strategy used to reduce the overall risk by creating a basket of crypto assets that decreases the risk of ruin. Usually, the crypto basket comprises different cryptocurrencies with different levels of volatility and other correlations among them.
Asset Allocation – It is the way how the portfolio is allocated. For example, riskier profiles tend to have more volatile assets. Meanwhile, moderate risk profiles give the assets similar to the main benchmarks of the market.
Rebalance – It is when the basket of assets changes. The rebalancing process usually comes when the market is changing, and some sectors could offer better opportunities at a lower risk. Therefore, it is primordial to make changes in the basket distribution and eventually take some names off to let others get in.

CHAPTER 5
RECAP

Trading is never easy and we know it’s a lot to process, especially for beginners.

If you’re still struggling to get started with your trading journey, here are some of the key takeaways from this lesson.

Trading risk management recap

The risk management techniques outlined throughout this guide will help you stay in the game longer. As the efforts for the adoption of cryptocurrencies gain traction worldwide, some of these risks associated with the crypto exchange risks will be eliminated. While these risk management practices may help you kickstart your trading journey, and perhaps help you formulate a better trading plan.

Still, it’s your responsibility as a trader to manage the inherent risk that comes with trading and investing in the cryptocurrency market.

To recap:

  • Always stay on top of the risk rule.
  • Know what’s your risk appetite and act accordingly.
  • What for your position sizes to help you control risk and maximize returns.
  • In case of doubts, always refer to the chart patterns to analyze the market conditions to strengthen your buying and selling decisions.

In a nutshell, trading risk management is an essential but often overlooked prerequisite to successful active trading. When it’s managed well, results will show.