Brief content
Risk management is an integral part of responsible investing and trading. This can reduce the overall risk of your portfolio in a number of ways. For example, you can diversify your investments, hedge against financial events or use 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 still somehow balance the risk of your investment with the return. However, risk management is more than just choosing less risky trades or investments. Risk management strategies offer a set of tools suitable for both experienced and novice investors.
What is risk management?
Risk management involves forecasting and identifying financial risks associated with investing, for their further minimization. Investors use a risk management strategy to reduce the risks of their portfolio. An important first step is to assess your current risk appetite and then build your strategies and plans around it.
Risk management strategies are plans and strategic actions that traders and investors take after identifying investment risks. These strategies reduce risk and can include a wide range of financial transactions, such as loss insurance and diversifying your portfolio across asset classes.
In addition to actively practicing risk management, it is important to understand the basics of risk management planning. There are four main planning methods that should be considered before embarking on a specific risk management strategy, as it will be based on the method chosen.
Four main methods of risk management planning
Acceptance: The decision to take a risk and invest in an asset without spending money to protect against potential losses because they are small.
Transfer: transferring the risk of an investment to a third party for a fee.
Avoidance: Refusal to invest in an asset with potential risk.
Reduction: reducing the negative financial consequences of risky investing due to portfolio diversification. This method can be implemented within the same or different asset classes and industries.
Why is risk management strategy important in cryptocurrency?
Cryptocurrencies are one of the riskiest investment asset classes available to the average investor. Cryptocurrency prices are very volatile, some projects fail, and blockchain technology can be quite complex to understand.
Due to the rapid development of cryptocurrencies, it is very important to use reliable risk management methods and strategies to reduce exposure to potential risks. They also help you become a more successful and responsible trader.
Read on to learn about 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 that allows you to risk no more than 1% of your total capital when investing or trading. If you have $10,000 to invest and want to follow the 1% rule, there are several ways to do this.
One is to buy $10,000 worth of BTC and set a stop loss or sell stop limit at $9,900. Here you will cut your losses by 1% of the total investment capital ($100).
In addition, it is possible to buy $100 ETH without setting a stop loss, because if the price of ETH falls to 0, the loss will not exceed 1% of the total capital. The 1% rule does not affect the size of the investment, but the amount that the trader risks when investing.
Because of market volatility, the 1% rule is especially important for crypto investors. In the pursuit of profit, many traders may invest too much and suffer huge losses in the hope of luck.
Strategy #2: setting stop-loss and take-profit orders
A stop-loss order uses a predetermined asset price at which the position will be closed. The stop price is set below the current price and when activated helps to protect against further losses. A take profit order works the other way around, setting a price at which you want to close your position and lock in some profit.
Stop loss and take profit help manage risk in two ways. First, they can be configured in advance and will be executed automatically. There is no need to be available 24/7 and your preset orders will work if prices are particularly volatile. It also allows you to set realistic limits on the losses and profits you can make.
Try to set these limits in advance rather than at the critical moment. Perhaps the use of a take-profit order is unusual for risk management, but do not forget: the longer you delay taking profits, the higher the risk of another market decline.
Strategy #3: Diversify and hedge
Diversifying your portfolio is one of the most popular and fundamental tools for reducing overall investment risk. Diversification of the portfolio helps to avoid investing too much in any one asset or asset class, which reduces the risk of large losses from it. For example, an investor can store many different coins and tokens, as well as provide liquidity and loans.
Hedging is a more advanced strategy of protecting profits or minimizing losses by buying another asset. Typically, these assets are inversely correlated. Diversification can be a kind of hedging, but perhaps the most famous example is futures.
A futures contract allows you to fix the price of an asset at a future date. Imagine, for example, that you believe that the price of Bitcoin will fall, so you decide to hedge against this risk and open a futures contract to sell $20,000 of BTC three months from now. If the price of BTC actually falls to $15,000 three months from now, you will have profited from your futures position.
It is worth remembering that futures contracts are settled financially, and you do not need to deliver the coins physically. In this case, the other party to the transaction pays the trader $5,000 (the difference between the spot and futures prices), which allows you to insure against the risk of a fall in the price of BTC.
As mentioned, the crypto world is volatile. However, there are still opportunities to diversify within this asset class and take advantage of hedging opportunities. Diversification is much more important in cryptocurrency than in more traditional financial markets with less volatility.
Strategy #4: Prepare an exit strategy
Having an exit strategy is a simple but effective method of minimizing the risk of large losses. By following the plan, you can lock in profits or cut losses at a predetermined point in time.
If traders are taking profits, they can forget about caution and hold positions even during periods of falling prices. In addition, the user's actions may be influenced by hype, maximalism or the mood of the trading community.
One of the ways to successfully implement an exit strategy is to use limit orders. You can set them to automatically trigger at your limit price, whether you want to lock in profits or set maximum losses.
Strategy #5: Do Your Own Research (DYOR)
DYOR is an essential risk reduction strategy for any investor. In the age of the Internet, checking information is not difficult. Before investing in a token, coin, project or other asset, you should exercise due diligence. It is very important that you check the important information about the project such as its whitepaper, tokenomics, partnerships, roadmap, community and other basic information.
However, it is worth considering that misinformation spreads quite quickly, and on the Internet any user can call his opinion facts. When doing research, think about where you get your information and the context in which it is presented. Cryptocurrency shilling is a common phenomenon, and some projects or investors may intentionally pass off false, biased or promotional news as truth.
Results
With five risk management strategies outlined, you'll have an effective set of tools to help reduce your portfolio's risk. Even using simple methods that cover most areas will help you invest more responsibly. Advanced traders can try advanced risk management plans with in-depth strategies.
For a deeper dive into the topic, please check out these articles:
How to manage risks 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 best hedging place for traders