TL;DR
Risk management is an essential component of responsible investing and trading. With it, you can reduce the overall risk of your portfolio in several 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 many investors and traders. Even if your risk tolerance is high, you should still somehow consider how risky your investments are relative to the potential return. However, risk management is not simply choosing trades or investments that supposedly present less risk. There is a comprehensive set of risk management tools and strategies and many of them are suitable for beginners too.
What is risk management?
Risk management involves predicting and identifying financial risks associated with your investments to minimize them. Investors employ risk management strategies to help them manage the risk exposure of their portfolios. An important first step is to assess your current exposure to risks and then build strategies and plans according to the identified risks.
Risk management strategies are strategic plans and actions that traders and investors implement after identifying investment risks. These risk reduction strategies can involve a wide range of financial activities, such as taking out loss insurance and diversifying the portfolio across different asset classes.
In addition to active risk management practices, it is important to understand the fundamentals of planning. There are four main planning methods you should consider before adopting a specific risk management strategy. It is the method you choose that will inform your preferred strategy.
Four Main Risk Management Planning Methods
Acceptance: Decision to take an investment risk in an asset, but not invest more money to avoid the risk, as the potential loss will not be significant.
Transfer: Paying for a certain cost to transfer the risk of an investment to a third party.
Decision to Avoid: Not investing in an asset with potential risk.
Reduction: Reduce the financial consequences of a risky investment by diversifying your portfolio. This method can be used within the same asset class or also between different sectors and assets.
Why is it important to have a risk management strategy in the crypto sector?
We know that cryptocurrencies, as an asset class, are one of the highest risk investments available to the average investor. Prices are volatile, projects can collapse overnight, and understanding blockchain technology can be challenging for newcomers.
With the rapid movements of cryptocurrencies, it is important to employ sound risk management practices and strategies to reduce your exposure to potential risks. This is also an essential step towards becoming a successful and responsible trader.
Read on and learn five risk management strategies that can benefit your cryptocurrency portfolio.
Strategy #1: Consider the 1% rule
The 1% rule is a simple risk management strategy that involves not risking more than 1% of your total capital on an investment or trade. If you have $10,000 and want to adhere to the 1% rule, you can invest in different ways.
One option would be to buy $1,000 worth of bitcoin (BTC) and set a stop-loss or stop-limit order to sell at $9,900. In this case, you would set a maximum loss of 1% of your total investment capital ($100).
You can also buy $100 worth of Ether (ETH) without setting a stop loss order, as you would lose a maximum of 1% of your total capital if the price of ETH drops to 0. The 1% rule does not affect the size of your investments , but the amount you are willing to risk on a given investment.
The 1% rule is especially important for cryptocurrency users due to market volatility. Some investors feel more greedy and may bet too much on an investment and even suffer large losses hoping that their luck will change.
Strategy #2: Set stop-loss and take-profit points
A stop-loss order sets a predetermined price for an asset at which the position will be closed. The stop price is set below the current price and, when triggered, helps protect the trader against larger losses. The take-profit order works the opposite way, setting a price at which you want to close your position and consolidate profits.
Stop-loss and take-profit orders help you manage risk in two ways. First, they can be configured in advance and will run automatically. There is no need to be available 24 hours a day and your predefined orders will be triggered if prices are at a time of increased volatility. This also allows you to set realistic limits on potential losses and profits.
It's better to set these boundaries in advance rather than in the "heat of the moment." It may seem strange to think of take-profit orders as part of risk management, but you should not forget that the longer you wait to consolidate profit, the greater the risk of the market falling again while you wait for a further move higher. .
Strategy #3: Diversification and hedging
Portfolio diversification is one of the most popular and fundamental tools for reducing overall investment risk. A diversified portfolio will not have a high investment in one asset or asset class. This minimizes the risk of large losses caused by a single asset or a specific asset class. For example, you can hold a variety of different coins and tokens, as well as provide liquidity and loans.
Hedging is a slightly more advanced strategy for protecting gains or minimizing losses through the purchase of another asset. Typically, this strategy involves inversely correlated assets. Diversification is a type of hedging, but futures contracts are perhaps the best-known example of this strategy.
A futures contract allows you to fix a price for an asset at a future date. Let's suppose you believe that the price of bitcoin will fall, so you decide to protect yourself (hedge) against this risk and open a futures contract to sell your BTC for US$20,000 after three months. If three months later the price of bitcoin actually falls to $15,000, you will profit from your futures position.
It is worth remembering that futures contracts are financially settled and you do not need to physically deliver the coins. In this example, the counterparty to your contract would pay you US$5,000 (difference between the spot price and the futures price) and you would have hedged against the risk of the bitcoin price falling.
As mentioned, the crypto world is volatile. However, there are still opportunities to diversify within this asset class and take advantage of hedging opportunities. In the crypto world, diversification is more crucial than in less volatile traditional financial markets.
Strategy #4: Have a defined exit strategy
Having an exit strategy is a simple yet effective method for minimizing the risk of large losses. By following the plan, you can make profits or minimize losses at a predetermined point.
It's common to want to continue making gains or rely too much on a cryptocurrency even when prices are falling. Getting caught up in hype, maximalism, or a certain trading community can also hinder your decision-making process.
A good way to implement an exit strategy is by using limit orders. You can set them to automatically trigger at your limit price, whether you want to consolidate profits or set a maximum loss amount.
Strategy #5: Do Your Own Research (DYOR)
Doing Your Own Research (DYOR) is a fundamental risk reduction strategy for any investor. In the age of the Internet, doing your own research has never been easier. Before investing in a token, coin, project or asset, you must do your due diligence. It is essential that you check essential information about a project, such as its whitepaper, tokenomics, partnerships, roadmap, community and other fundamentals.
However, misinformation spreads quickly and anyone can post opinions online as facts. When conducting research, consider where you are getting your information and the context in which it is presented. Often, projects or investors spread news about false or biased promotions, in an attempt to persuade users and investors.
Final considerations
With these five risk management strategies, you'll have an effective toolkit to help reduce your portfolio risk. Even using simple methods can help you invest more responsibly. On the other hand, there is potential to create risk management plans with more advanced and in-depth strategies.
To delve deeper into the subject, see the following articles:
How to Manage Risk and Trade Responsibly | Binance Support
What is the Risk/Reward Ratio and How to Use it? | Binance Academy
3 Reasons Why Binance Futures is the Favorite Place Among Traders for Hedging
