Summary
Risk management is an important part of responsible investing and trading. Risk management can reduce the overall risk of your portfolio in a variety of ways. For example, you can diversify your investments, hedge against financial events, or implement simple stop-loss and take-profit orders.
Introduction
Minimizing risk is a priority for most investors and traders. Even if you have a high risk tolerance, you will still compare the investment risk with the return. However, risk management is more than just choosing trades or investments with lower risk. There is a comprehensive set of tools for risk management strategies. Most of them are suitable for beginners.
What is risk management?
Risk management involves predicting and identifying financial risks associated with your investments in order to minimize them. Then, investors apply risk management strategies to help them manage their portfolio risk exposure. An important first step is to assess your current exposure, and then create a strategy and plan based on that assessment.
Risk management strategies are strategic plans and actions implemented by traders and investors after identifying investment risks. This strategy reduces risk and can cover a wide range of financial activities, such as taking out liability insurance and diversifying a portfolio with different asset classes.
In addition to active risk management practices, you must understand the basics of risk management planning. There are four main planning methods that you should consider before implementing a particular risk management strategy, as the method chosen will lead you to the desired strategy.
Four main risk management planning methods
Acceptance: Deciding to bear the risk of investing in an asset, but not spending money to avoid it because the potential loss is not significant.
Assignment: Transferring investment risk to a third party for a fee.
Avoidance: Not investing in an asset that has potential risks.
Reduction: Reducing the financial consequences of risky investments by diversifying a portfolio. Diversification can be done within the same asset class or even across different industries and assets.
Why is a risk management strategy important in crypto?
It is common knowledge that as an asset class, crypto is one of the higher risk investments available to investors in general. Prices can prove to be volatile, projects can crumble overnight, and the technology behind blockchain can be difficult for beginners to understand.
With the rapid movement of crypto, you must implement good risk management practices and strategies to reduce exposure to potential risks. This action is also an important step in becoming a successful and responsible trader.
Read on to learn five risk management strategies that can benefit your crypto portfolio.
Strategy #1: Consider the 1% rule
The 1% rule is a simple risk management strategy of not sacrificing more than 1% of total capital on an investment or trade. If you have $10,000 to invest and want to adhere to the 1% rule, there are several ways to do it.
One is to buy $10,000 worth of bitcoin (BTC), then set a stop-loss order or stop-limit order to sell for $9,900. Under these conditions, you will limit losses at 1% of the total investment capital ($100).
You can also buy $100 worth of ether (ETH) without setting a stop-loss order, as you will only lose a maximum of 1% of your total capital if the price of ETH falls to 0. The 1% rule affects not the size of the investment, but rather the amount you are willing to sacrifice for an investment.
The 1% rule is especially important for crypto users because of the volatility of the market. It is easy for investors to become greedy. Additionally, some investors may allocate too much in one investment and even experience large losses while hoping that their fortunes will turn around.
Strategy #2: Set stop-loss and take-profit points
A stop-loss order sets a specific price to close a position on an asset. The stop price is set below the current price. When triggered, these prices help protect against larger losses. Take-profit orders have the opposite function. This order sets the desired price to close the position and locks in a certain amount of profit.
Stop-loss orders and take-profit orders help manage your risk in two ways. First, the order can be set in advance and will be executed automatically. You don't have to monitor it 24/7 and preset orders will be triggered if the price becomes volatile. This strategy allows you to set realistic limits for losses and profits that can be taken.
You should set this limit in advance rather than when volatility occurs. While it may seem strange to think of take-profit orders as part of risk management, you should not forget that the longer you wait to take profit, the higher the risk that the market may fall again while you wait for additional increases.
Strategy #3: Diversification and hedging
Diversifying your portfolio is one of the most popular and fundamental tools for reducing your overall investment risk. A diversified portfolio will not invest too heavily in any one asset or asset class, thereby minimizing the risk of large losses from one particular asset or asset class. For example, you can own a wide variety of coins and tokens, as well as provide liquidity and loans.
Hedging is a slightly more advanced strategy for protecting profits or minimizing losses by purchasing another asset. Typically, these assets have conflicting correlations. Diversification can be a type of hedging, but perhaps the best known example is futures.
Futures contracts allow you to lock in the price for an asset at a future date. For example, you believe that the price of bitcoin will fall. So, you decide to hedge this risk and open a futures contract to sell BTC for $20,000 in three months. If the price of bitcoin does fall to $15,000 three months later, you will make a profit on the futures position.
It is worth remembering that futures contracts are settled financially. You don't have to physically send the coins. In this condition, the person on the other side of the contract will pay you $5,000 (the difference between the spot price and the futures price) and you have hedged against the risk of the bitcoin price falling.
As already discussed, the crypto world is volatile. However, there is still an opportunity to diversify within this asset class and use hedging opportunities. Diversification in crypto is much more important than in more traditional financial markets with lower volatility.
Strategy #4: Have an exit strategy in place
Having an exit strategy is a simple but effective method to minimize the risk of major losses. By following the plan, you can take profits or limit losses at a certain point.
Investors often want to continue when they make a profit or are too confident in a cryptocurrency even if the price falls. Following euphoria, maximalism, or trading communities can also trick your decision making.
One way to successfully implement an exit strategy is to use limit orders. You can set it to automatically trigger at the limit price, either to take profit or set a maximum loss.
Strategy #5: Do Your Own Research (DYOR)
DYOR is an integral risk reduction strategy for every investor. In the Internet era, research has become very easy to do. Before investing in a token, coin, project, or other asset, you should do your due diligence. You should check important information about a project, such as whitepaper, tokenomics, partnerships, roadmap, community, and other fundamentals.
However, misinformation spreads quickly and anyone can pass off an opinion online as fact. When conducting research, consider the origin of your information and the context in which it is presented. Shilling (endorsement) is a common practice. Projects or investors may spread false, biased news or promotions that appear to be genuine and factual.
Closing
With a breakdown of these five risk management strategies, you will have an effective set of tools to help reduce portfolio risk. Applying even simple methods that cover most areas can help you invest more responsibly. On the other hand, there is the potential to create risk management plans with in-depth advanced strategies.
To explore this topic further, read the following articles:
How to Manage Risk and Trade Responsibly | Binance Support
Explanation of the Risk/Reward Ratio and How to Use It | Binance Academy
3 Reasons Why Binance Futures Is the Hedging Tool of Choice for Traders
