Risk Management – An Essential for Beginners

Introduction

“All covet, all lose” hardly applies so well as it does to the world of cryptocurrency and similar volatile investments. Since risk can only be minimized, but not taken out of equation altogether, it is wise to manage the risk appropriately. However, risk management itself requires adequate understanding of the nature of the problem: how many kinds of risks there are, and what strategies are to be adopted in response.

Before moving ahead, it is important to keep in mind that risk is inherent to our lives, from crossing a road, driving a car, dealing with a stranger, or investing money. But the only difference is that we manage everyday risks unconsciously. Risks in financial matters need deliberate efforts and elaborate planning.

Risk management in investment is not just a requirement; it is a systematic framework adopted by an individual or a company. The framework includes all the groundwork, comprising detailed analysis of the amount of risk and potential reward, leading to comprehensive strategies to avoid the risk as much as possible. Besides, the framework features taking care of various assets classes like cryptocurrencies, stocks, indices, futures, and commodities.

The Types of Risk

It is impossible to ensure risk management unless you know how many types of risks there are in the market in which you are investing or planning to invest.

Market Risk  

Market risk is related to the price action of the asset you are trading. For example, you are trading a cryptocurrency on a weekend, there is usually low risk involved because of comparatively low trading volume. But any fundamental event can bring wild swings, which need to be taken into account when starting a trade. Tight stop-loss and take-profit orders may ward off market risks and save you from serious losses.

Liquidity Risk

Liquidity risk comes into play when you choose a cryptocurrency whose market cap is on the lower side. Obviously, even a slight injection into or capitulation out of the asset may cause unforeseen price action and wreak havoc with your trade. You should choose the coins as high on the market cap ranking as possible, so that it is difficult to manipulate.

Credit Risk

Credit risk is valid in the crypto market only when you take long or short positions from your futures wallet because you borrow from the exchange on which you trade. Exchanges with low volume offer a very high leverage to attract maximum traders, bringing in a very high risk of liquidation. To avoid this risk, only well-known exchanges with higher volume should be selected.

Operational Risk

Operational risk arises when you choose a single coin and put all your money into it. Now your fate is locked with that of the coin. If it goes to moon, so does your portfolio, and if it plummets, the same fate meets your investment. Diversification is the solution for such risks.

Systemic Risk

Systemic risk means you have diversified your investment but selected all coins of the same narrative. For example, you feel that AI will be the narrative in this cycle and select many coins with an AI tag. The solution is that you choose different narratives like RWA, DeFi, Layer1, Layer 2, etc.

The Process of Risk Management

After identifying the risk types, you must know how risk management works.

Setting Objectives  

At the outset, you must set objectives: how much risk you can afford to take. If you cannot afford to lose too much money, select low-risk low-reward coin with higher market cap. Greed can drive you to choose low-cap coins with a hope to gain 50x-100x profits, but such coins can tank aggressively, and you may go down with the ship. There is serious liquidity risk involved here.  

Identification of Risk

In the next step, you need to identify how many risks you are exposed to. Market risk is always there, but diversification and choosing the right exchanges can shield you from other risk types mentioned above. In addition, there can be fundamental events that can trigger dumps or pumps. All internal and external factors must be kept in mind. Subsequently, risks must also be graded in order of their severity or frequency.

Selecting the Response

The decision and selection of an appropriate response is the next step in the process of risk management. The type of response may vary depending on the type of risk and its severity.

Monitoring

Monitoring is the final step. If you leave your portfolio after all the aforementioned steps, your hard work goes in vain. Analysis of technical and fundamental data is necessary to make the risk management process a success.

Strategies to Minimize Risk

In order to save investment from the impact of the risks, one or a combination of many key strategies are employed by investors and traders.

1% Trading Rule

1% trading rule is a conservative strategy used by day traders and scalpers, sometimes even by swing traders. Using this strategy, they take trade either for 1% of the total wallet amount or limit their TP or SL to 1%. Even less than 1% is common among the investors with heavier investments.

SL and TP Orders

Stop-loss and take-profit orders limit losses to a great deal. Stop-loss makes sure that if the market plummets, loss is not more than a predefined value. Similarly, take-profit orders enable you to make some gain if market booms.

Hedging

Hedging is a market-neutral strategy that lets traders open long and short positions simultaneously. Renowned central exchanges offer hedging options in futures trading.

Diversification

Diversification, as has been hinted before, is a key strategy in minimizing losses. You should choose different narratives and scatter your investment in top 3-5 coins in every narrative. This strategy saves you from operational and systemic losses.

Risk-Reward Ratio

The calculation of risk-reward ratio is also a strategy to save yourself from financial setbacks. Simply put, the risk-reward ratio is the potential loss divided by potential profit. For example, you want to take a profit at price 20% higher than the entry price, and stop loss at price 10% lower, the risk-reward ration is 1:2. Anything equal to or higher than this ratio is considered good.

Conclusion

Risk management in the crypto market in particular and finance in general is an essential framework. It involves understanding the nature of risk, the process of risk management and adopting necessary strategies in response.