Risk management is an essential part of responsible investing and trading. It can reduce your portfolio's overall risk in various ways — for example, you may diversify your investments, hedge against financial events, or implement simple stop-loss and take-profit orders.
Minimizing risk is a priority for many investors and traders. Even if your risk tolerance is high, you'll still, in some way, weigh the risk of your investments versus the payoff. However, there's more to risk management than simply choosing less risky trades or investments. A comprehensive toolset of risk management strategies is available, many of which are suitable for beginners, too.
What is risk management?
Risk management entails predicting and identifying financial risks involved with your investments to minimize them. Investors then employ risk management strategies to help them manage their portfolio's risk exposure. A critical first step is assessing your current exposure to risks and then building your strategies and plans around them.
Risk management strategies are plans and strategic actions traders and investors implement after identifying investment risks. These strategies reduce risk and can involve a wide range of financial activities, such as taking out loss insurance and diversifying your portfolio across asset classes.
In addition to active risk management practices, it is important to understand the basics of risk management planning. There are four key planning methods you should consider before embarking on a specific risk management strategy, as the method you choose will inform your preferred strategy.
Four key risk management planning methods
Acceptance: Deciding to take on the risk of investing in an asset but not spending money to avoid it as the potential loss isn't significant.
Transference: Transferring the risk of an investment to a third party at a cost.
Avoidance: Not investing in an asset with potential risk.
Reduction: Reducing the financial consequences of a risky investment by diversifying across your portfolio. This could be within the same asset class or even across industries and assets.
Why is a risk management strategy important in crypto?
It's common knowledge that crypto, as an asset class, is one of the higher-risk investments available to the average investor. Prices have proven to be volatile, projects can crash overnight, and the technology behind blockchain can be challenging for newcomers to understand.
With crypto moving rapidly, it's imperative to employ sound risk management practices and strategies to reduce your exposure to potential risks. This is also an essential step to becoming a successful and responsible trader.
Read on to find out 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 entails not risking more than 1% of your total capital on an investment or trade. If you have $10,000 to invest and want to adhere to the 1% rule, there are a few ways to do so.
One would be to purchase $10,000 worth of bitcoin (BTC) and set a stop-loss or stop-limit order to sell at $9,900. Here, you would cut your losses at 1% of your total investment capital ($100).
You could also purchase $100 of ether (ETH) without setting a stop-loss order, as you would only lose a maximum of 1% of your total capital if the price of ETH were to drop to 0. The 1% rule doesn't affect the size of your investments but the amount you are willing to risk on an investment.
The 1% rule is especially important for crypto users due to the market's volatility. It can be easy to get greedy, and some investors may put too much into one investment and even suffer heavy losses expecting their luck to turn.
Strategy #2: Setting stop-loss and take-profit points
A stop-loss order sets a predetermined price for an asset at which the position will close. The stop price is set below the current price and, when triggered, helps protect against further losses. A take-profit order works the opposite way, setting a price at which you want to close your position and lock in a certain profit.
Stop-loss and take-profit orders help you manage your risk in two ways. First, they can be set up in advance and will be executed automatically. There's no need to be available 24/7, and your pre-set orders will be triggered if prices are particularly volatile. This also allows you to set realistic limits for the losses and profits you can take.
It’s better to set these limits in advance rather than in the heat of the moment. While it can be strange to think of take-profit orders as part of risk management, you shouldn't forget that the longer you wait to take profit, the higher the risk the market could fall again while waiting for an additional upside.
Strategy #3: Diversify and hedge
Diversifying your portfolio is one of the most popular and fundamental tools to reduce your overall investment risk. A diversified portfolio won't be too heavily invested in any asset or asset class, minimizing the risk of heavy losses from one particular asset or asset class. For instance, you may hold a variety of different coins and tokens, as well as provide liquidity and loans.
Hedging is a slightly more advanced strategy to protect gains or minimize losses by purchasing another asset. Usually, these assets are inversely correlated. Diversification can be a type of hedge, but perhaps the most well-known example is futures.
A futures contract lets you lock in a price for an asset at a future date. Imagine, for instance, you believe bitcoin's price will tumble, so you decide to hedge against this risk and open a futures contract to sell BTC for $20,000 in three months. If bitcoin’s price does indeed fall to $15,000 three months later, you will profit from your futures position.
It's worth remembering that futures contracts are settled financially, and you don't have to deliver the coins physically. In this case, the person on the other side of your contract would pay you $5,000 (the difference between the spot price and the futures price), and you would have hedged against the risk of bitcoin’s price falling.
As mentioned, the crypto world is a volatile one. However, there are still opportunities to diversify within this asset class and use hedging opportunities. Diversification in crypto is much more crucial than in more traditional financial markets with less volatility.
Strategy #4: Have an exit strategy ready
Having an exit strategy is a simple but effective method for minimizing the risk of heavy losses. By sticking to the plan, you can take profits or cut losses at a predetermined point.
Often, it's easy to want to keep going when making gains or to put too much faith in a cryptocurrency even when prices are falling. Getting caught up in hype, maximalism, or a trading community can also cloud your decision-making.
One way of successfully implementing an exit strategy is to use limit orders. You can set them to automatically trigger at your limit price, whether you want to take profit or set a maximum loss.
Strategy #5: Do Your Own Research (DYOR)
DYOR is an integral risk-reduction strategy for any investor. In the Internet age, it's easier than ever to conduct your own research. Before investing in a token, coin, project, or other asset, you must do your due diligence. It's key that you check essential information about a project, such as its white paper, tokenomics, partnerships, roadmap, community, and other fundamentals.
However, misinformation spreads quickly, and anyone can submit their opinions online as facts. When conducting research, consider where you're getting your information and the context in which it's presented. Shilling is commonplace, and projects or investors can spread false, biased, or promotional news as if it were sincere and factual.
With the five risk management strategies outlined, you'll have an effective tool kit to help reduce your portfolio's risk. Even employing simple methods that cover most areas will help you invest more responsibly. At the other end of the scale, there's potential to create risk management plans with more advanced, in-depth strategies.
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