- Digital asset risk management is something that should be considered before opening a trading position or allocating capital to an on-chain portfolio.
- Employing proper risk management strategies can help investors mitigate losses to retain value as well as capture profits during positive moves in the market.
- Digital asset or crypto risk management involves setting objectives, identifying risks, risk assessment, defining responses, and monitoring.
- The 1% risk rule, setting stop-losses and take-profits, hedging and portfolio diversification are common risk management strategies.
In short, digital asset risk management is about identifying, assessing, and monitoring risks, according to the context and strategy. The process of managing digital assets and crypto risks aims to evaluate the risk/reward ratio so the most favorable positions can be prioritized.
While there are countless stories of great fortunes being made through investing, in both the cryptocurrency as well as traditional markets, the fact of the matter is that all forms of investing carry some form of risk.
There are many different types of cryptocurrency risk factors, but most of them relate to fluctuations in the market that cause unexpected price movements that go against what traders were expecting. For that reason, understanding and implementing proper risk management is a key area that every investor should diligently study before even thinking about investing their hard-earned money in the markets.
What Is Risk Management?
Everyday life is full of all sorts of risks that many of us overlook or take for granted due to experience – risks that could upend our lives at any moment. From driving a car to choosing the right dentist, risk management is all about doing a proper assessment of, and reacting to, risk.
When it comes to managing risk in financial markets, proper application can mean the difference between a margin call and wealth preservation. And the only way to practice good on-chain risk management is to remain diligent and employ various forms of analysis and best-use practices.
In the realm of economics, risk management is often described as the framework a company or investor employs to handle financial risks, which are a common occurrence in the world of business.
For traders and investors, a digital asset risk management framework can include things like strict limits to position sizes and asset diversification into multiple classes including cryptocurrencies, real estate, stocks, commodities, Forex and indices.
Here’s a closer look at how risk management works, what are some cryptocurrency risk factors and some strategies that can be employed to help investors in their plight to preserve and increase their wealth.
How Does Risk Management Work?
Risk management generally includes five steps, which can vary slightly depending on the context: setting objectives, identifying risks, risk assessment, defining responses, and monitoring.
This step involves defining the main goals of risk management. This is usually influenced by an investor's risk tolerance, or how much digital asset risk they are willing to take to achieve their investment objectives.
During the identification period, potential digital asset and crypto risks are detected and defined. The goal is to uncover the various factors that could lead to negative outcomes.
Once the risk factors are identified, they need to be evaluated to determine their frequency and severity. All present risks can then be ranked in order of importance to help investors determine which require immediate action.
Responses for each form of risk are defined based on their level of importance. They specify which actions need to be taken if the risk manifests.
This is the final step, which involves monitoring the framework's efficiency in responding to events. This typically involves the continuous collection and analysis of data.
Financial Risk Management
Trade setups can fail for a variety of reasons, so a comprehensive digital asset risk management system is vital for the long-term health of a financial portfolio. Fast-moving markets can go against a “surefire” bet in an instant, causing emotional reactions in a state of panic that oftentimes only compounds the losses that had already occurred.
In the heat of the moment when your wealth is quickly evaporating, initial strategies can get thrown out the window in a bid to revenge trade the market. This is especially true during bear market periods and capitulation events.
It is well known in financial circles that employing a proper risk management strategy significantly improves an investor's chances of success, and many of the practices are easy to employ – meaning a small effort can pay off big time. Setting stop-loss or take-profit orders are a couple of examples.
A thorough trading strategy should include a clear set of possible actions and crypto risks that traders can refer to during volatile or placid markets, which helps to remove emotion from the equation. There are a variety of other ways to manage risks, and dedicated investors would be wise to continuously revise and update their strategies if market conditions change.
Here are some examples of common financial and cryptocurrency risks and a brief description of how investors lessen their effects.
- Market risk: Stop-loss orders on every trade allows poor-forming positions to be automatically closed before incurring bigger losses.
- Liquidity risk: Minimized by only trading in high-volume markets with greater liquidity.
- Credit risk: Reduced by trading on established, trustworthy exchanges.
- Operational risk: Diversification is the main way to mitigate operational risk as it helps avoid overinvestment in a single project or company. Due diligence and research also help avoid operational malfunctions.
- Systemic risk: Diversification into different sectors of the economy or industries with a low correlation helps to reduce systemic risk.
Common Risk Management Strategies
As mentioned above, there are a variety of risk management approaches that investors can take, depending on the market. A combination of tools often provides the best protection, but not all strategies apply to every asset. Here are some common digital asset risk management strategies that investors use to help mitigate risk.
1% Trading Rule
The 1% trading rule, also referred to as the 1% risk rule, involves limiting the losses an asset is capable of inflicting upon a trader's portfolio to 1%. To achieve this, no more than 1% of the total value of the portfolio should be invested into any one asset. Bigger orders with a stop loss equal to 1% of the portfolio’s value can also be applied with a similar outcome.
The 1% rule can be adjusted depending on the size of a portfolio and an investor's risk tolerance. In the case of larger portfolios, a position size smaller than 1% is often advised as the dollar amount of the loss is greater for high-value portfolios.
Stop-Loss and Take-Profit Orders
Stop-loss orders allow traders to automatically limit losses when a market turns against them. And as every crypto trader knows, the cryptocurrency market can reverse course in an instant, so take-profit orders can help to lock in profits when a trade has performed well.
Wise traders that employ optimal risk management choose stop-loss and take-profit levels before they enter a position, and set them as soon as the trade has been opened.
These also help by removing emotion from the equation, which can lead investors to ruin during times of heightened volatility and tumbling prices.
Hedging is a financial risk mitigation strategy that involves opening two positions that offset each other. It allows traders to hedge one trade by making an opposing trade of equivalent size.
If done correctly, hedging can help reduce the impact of major market moves while also allowing investors to potentially capitalize on moves in either direction. In the volatile crypto markets, properly hedged investors can often make money on both sides of a strong price fluctuation.
A well-diversified portfolio is one of the best ways an investor can protect against oversized portfolio losses while at the same time giving them exposure to a breadth of asset classes that move uncorrelated.
Holding an entire portfolio in just one asset or asset class – especially a crypto-only portfolio – opens you to substantial losses if that asset or class falls out of favor. Cryptocurrencies are well known for losing 80-100% of their value in bear markets, so crypto-only portfolios expose their holders to the significant downside that happens on a routine basis.
An assets risk-reward ratio is a calculation that shows the potential upside of that asset relative to the crypto risks involved. Risk-reward ratios are calculated by dividing the potential loss by the potential profit. If a trader sets their stop-loss at 3% and is looking to bank a 15% profit, then their risk-reward ratio would be 1:5, meaning the potential profit is five times higher than the risk.