Over the years, trading digital currencies has become more than just a hobby or a way of earning a passive income, for some it has become a lifestyle. Thanks to its volatile nature, some of these traders have benefited greatly from it. In the last year alone, while the major digital currencies have experienced a tremendous increase in their prices, some alternative coins have not fallen behind either. Although as a trader I have profited greatly from the high volatility of most digital assets, I have had to consider certain aspects of digital trading to help me make better decisions. One such aspect is risk management.
For every trader, especially those trading digitals, managing risk is something that should never be ignored because it deals with the likelihood of things going south with your trade. While one prepares for profits, the probability of encountering a loss should also be given a major priority. When trading, risks concern the possibility of your trade not going as you intend. For this reason, certain rules have been set for traders to follow to reduce their level of risk when trading. However, before that, you need to understand the risks involved in trading digital assets as this will give you a better understanding of why risk management is a compulsory discipline to master.
Types of Risks
When trading, there are some major risks I consider, and they are: legal risk, credit risk, market risk, liquidity risk, and operational risk. Managing these five risks effectively can help reduce the amount of loss incurred while trading.
Regarding legal risks, this has to do with the negative impact of regulatory rules on your trading activities. Credit risk on the other hand has to do with the probability of failure to fulfill certain obligations on the part of those handling the trading platform. Risks like this are mostly theft concerned. A perfect example is when a trading or exchange platform is infiltrated by hackers, like the case of Binance in 2019. Market risk (which is the most common) has to do with the possibility of the price going according to your trade or against it. In digital trading, liquidity risk involves a trader's inability to convert their digital assets into Fiat currency due to insufficient funds. Operational risk is somewhat similar to liquidity risk, but it involves a trader’s inability to perform any activity on his trading account. With a clear understanding of the five risks stated above, you are armed with what to expect during your digital currency trades and should be no longer riddled with uncertainty.
Risk Management Strategies
When managing risk while trading digital assets, one should not risk more than one can afford to lose as this is a general rule of thumb in all trading. Risk management is categorized into three sections: the risk to reward ratio, stop loss and take profit, and position sizing. The risk/reward ratio involves a comparison between the level of risk and the actual returns. Trades with more risk attract higher rewards. Because we understand the risk-to-reward ratio, we know when to enter a trade and 80% of the time when a trade is unprofitable.
Stop-Loss and Take Profits
When I mention stop loss or take profit, it is not new (at least not to those conversant with trading terminologies) but to be clear, Stop Loss involves an executable order which closes an open position due to the decrease in price at a certain barrier. While Take Profit executes a liquidation of open orders when the price rises to a particular level. They are both great at managing risk. Stop Losses prevent unprofitable deals while Take Profits allow you to exit trades before the market turns against you.
With position sizing, we know how much we are willing to invest in a particular trade and how much loss we are prepared to incur. As per the rule of not putting all our eggs in one basket, we never invest more than 10% of the budget in any single trade. Also, with position sizing, we can tell how many digital tokens we are willing to buy. With the help of the enter-amount and risk-amount, which determines the amount I’m willing to invest and the one we’re willing to risk (should my trade fail), we can determine the percentage of our loss which is never above 2%. Because position sizing diversifies our investment, a risk amount of not more than 2% is used for every trade while trading sessions are limited to about 6%. Opening no more than three positions with 2% per position or six with 1% per open position, we’re able to minimize the loss. This strategy is, according to the perceived wisdom as the sharks and piranha approach. Finally, in position sizing we make use of the JPFS criterion which helps us determine the percentage of capital to use in opening a trade. This is mostly suitable for long-term trades.
Disciplined Volatility Trading
Trading a market as volatile as digital assets involves a lot of risk. However, for a disciplined trader, this serves as an opportunity for profit. Although the digital asset market is highly unpredictable and full of risks due to its high volatility, this is also what makes it one of the most profitable markets to trade in. It has become clear that digital asset volatility is not going away any time soon, and even with its current instability, as disciplined traders there are certain factors that we always consider while trading and they are the types of investor in the market, market immaturity levels, and the lack of regulation.
Being used to the market, we discovered that most digital traders are passive traders, and some are yet to understand that the market is still immature and the technology behind digital assets continues to evolve. Due to its decentralization, and because we understand that these are some of the driving forces behind digital currency volatility, we know how to read the market better and profit from it. One of the major reasons why most traders shy from trading digital currencies is because of their volatility, but with a disciplined trader, volatility is more of a blessing.
Not Holding on to Positions
Digital asset volatility may be good and highly profitable for a disciplined trader, but while trading it is not always advisable to hold on to positions for too long. The reason for this is because the market is unstable and could change at any time. The prices of digital currencies are likely to change at any time and they can either increase or decrease, which is bound to either work in your favour as a trader, or against you. Because we have an understanding of how very likely these market changes are to occur, we avoid holding on to positions for too long.
In the last year, digital assets have experienced more volatility than most other preceding years. Regardless of this however we have been able to benefit from this volatility because we understand when to enter and when to exit our positions.
Ethereum and Bitcoin Mimic Each Other
In recent years, Ethereum and Bitcoin have been advancing at the same time, although not at the same pace. For instance, whenever the price of Bitcoin increases, that of Ethereum increases along with it. The same is the case with an increase in the price of Ethereum. In most cases also, the increase or decrease in the price of Bitcoin affects that of other alternative coins. This side-by-side race of digital currencies has been going on for some time in recent years. As a professional trader, understanding the relationship between Bitcoin and Ethereum in this way helps us make better trading decisions.
Take the increase in the price of Bitcoin in early January 2020, which gave way to an increase in the price of other coins. During this time, major digital currencies experienced an all-time high, and most traders took advantage of this to make a profit. From this, we can deduce that this ‘coin race’ will continue for some time.
Ripple (XRP) Holding Strong Despite Lawsuits
In recent months, Ripple (an alternative coin) has been under serious heat from the Securities and Exchange Commission (SEC). Brad Garlinhouse the CEO of the company was charged with conducting unregistered securities transactions. And although they were charged with the sales of unregistered XRP securities worth $1.3 billion, they had tried to settle the case, even before the lawsuit.
Despite all these challenges, the price of the digital currency has remained stable. In early January this year, most major digital assets experienced a tremendous price increase, and Ripple was one of such coins and this was mostly due to an increase in the price of Bitcoin as mentioned above. Though there seems to be an evening in the market right now, we look forward to what the coming months hold for the digital asset market. Even so we believe that regardless of what the market brings, there will be multiple opportunities for returning a profit.