Cryptocurrencies are becoming increasingly popular as financial assets to trade with, and many people are joining the market hoping to make a big profit. However, since this is a relatively new asset class that is highly volatile, proper risk management is essential when dealing with the crypto market. Cryptocurrencies are digital assets whose value is determined by market demand and supply, not by any underlying asset or central authority. As a result, this market can quickly become unpredictable and chaotic.

Inexperienced traders without proper risk management run a high risk of suffering significant losses instead of the expected profits. Therefore, examining crypto trading risk management and discussing the best steps to make trading more profitable and less risky is crucial.

What is risk management in crypto trading, and why is it important?

Crypto trading risk management is a crucial aspect of trading in the cryptocurrency market. It involves using various tools and decision-making techniques that help traders limit their exposure to risks. Due to high volatility, inexperienced traders must know the risks when trading cryptocurrencies and implement appropriate risk management strategies. As a result, they might feel that their trading is going well, but once volatility hits, they may lose all their profits and even incur significant losses. However, with the help of risk management, traders can be prepared for such events and know what to do in such situations. By implementing different strategies, traders can even avoid such events altogether.

Risk management is a crucial mechanism that every trader should have in place. Every successful trader who consistently makes profits has some form of risk management integrated into their trading strategy. When we hear “risk management,” we may assume it is only for limiting losses, but there is more to it. Effective risk management leads to better trading strategies. By analyzing different factors to develop this management system, we can gain more insight into the market and discover previously unidentified opportunities.

Crypto trading risk management

Every trader should create a risk management strategy tailored to their unique trading style and preferences. While there is no one-size-fits-all solution, there are some key components that every risk management system should include. This article will discuss these essential elements and how they can help traders mitigate risk in their trades.

Have a good trading plan.

A good trading plan is crucial to succeed while limiting your potential risk exposure. Trading based solely on emotions and a casual overview of the market may yield profits, but such trades are difficult to spot and are usually based on luck and timing. To have a successful and long career in trading, it’s essential to have a well-crafted trading plan that includes risk management tools and strategies.

A trading plan is a comprehensive system that includes all the components necessary for successful trading, such as strategies, indicators, charts, assets, tools, and related aspects. Traders find a winning formula through trial and error; no one starts with a perfect plan. However, once you find a strategy that works, profits will come in.

Limit leverage usage

It is crucial to consider the amount of leverage when trading cryptocurrencies. Leverage is a trading technique that involves borrowing funds from a broker to boost your trading volume. For instance, if you have $100 to trade with and use 1:10 leverage, you can trade with $1000. The additional $900 is provided by the broker as a loan.

When trading with leverage, you risk losing money quickly if the market moves against you. This is because your losses are amplified due to the leverage. Brokers usually have a liquidation price, which is the price at which your position is automatically closed, resulting in a complete loss of your funds. Since cryptocurrencies are highly volatile, this liquidation price can be easily reached without giving you enough time to react. The liquidation price also depends on the amount of leverage you are using. As leverage increases, the liquidation price will be closer to your entry price. If you use very high leverage, your position can get liquidated even with a slight movement in the opposite direction of your trade.

One of risk management’s most crucial aspects is using leverage cautiously, especially in the case of cryptocurrencies, which are already high-volatility assets. It is advisable to use low leverage, as the potential profits are still substantial even with low leverage, while the potential losses are manageable.

You can only trade with an amount of money you can afford to lose.

This advice is particularly important for newcomers to trading, although it applies to everyone. Regarding financial markets, cryptocurrencies can be particularly challenging to understand as they are largely speculative assets. As a result, if you’re new to the world of crypto trading, you should not assume that you’ll only make profits and won’t lose any money.

When you start your journey in crypto trading, it’s important to try out different ideas, strategies, indicators, charts, trade with different currencies, and more to understand how it all works. However, this experimentation can come with a high possibility of loss. To minimize the impact of these losses, we recommend trading with money you can afford to lose. This approach allows you to be more experimental and not suffer significant losses. It will also help you better understand the market and find what works and doesn’t work for you.

Diversify your trading activity.

When trading with cryptocurrencies, it’s important to diversify your trading activity and size your positions correctly. This means you should never use most of your money to open a position. Successful traders only use a portion of their trading capital to open a position. If they want to trade with all their capital, they will use multiple positions and never one.

It is crucial to understand that when you use all your trading capital to open a position, you put all your money at risk, especially when using leverage. Cryptocurrencies are highly volatile assets, and sudden price swings are common, which can result in losing everything quickly. To mitigate this risk, it is advisable to never put more than 10% of your trading funds in one position. If you have a large trading balance, keeping each trade between 3% and 5% of your balance is recommended to minimize the risk. Although you can open larger positions for more significant profits, it is important to consider the higher risk involved and be prepared if the trade goes wrong.

Use stop-loss and take-profit orders.

Stop-loss and take-profit orders are the best risk management tools for trading cryptocurrencies. Always eyeing the market can be challenging, especially if you’re not a full-time trader. This is particularly true for newcomers still getting the hang of crypto trading. Implementing stop-loss and take-profit orders in your open positions is highly recommended. Doing so can help you manage your risks more effectively and minimize potential losses.

When trading, a stop-loss order limits potential losses. When you have an open position, you can place a stop-loss order that indicates how much of a loss you are willing to take before the position should be closed out. 

Suppose you had opened a position of ETH/USD when the price of Ethereum was $1700. You can set a stop-loss order at $1600 to minimize your potential loss. This order ensures that if the price of Ethereum falls to $1600, your position will be automatically closed. By doing this, you can limit your loss to about 5.8% of your initial investment (assuming you are not using leverage) and control the maximum amount of money you might lose.

If you want to limit these losses further, you can manually close a position before it reaches the set stop-loss level.

A take-profit order is a trading feature that works oppositely to a stop-loss order. It helps guarantee profits and prevent a situation where you must remember to close a position and miss out on potential profits due to a falling price. 

Before opening a position, you should know where the price is heading and what to expect. Based on that, you can place a take-profit order at a specific price mark to satisfy you with the profits made.

Take-profit orders have some downsides to consider. For instance, if the asset’s price keeps rising after hitting the take-profit point, you may miss out on potential profits. To overcome this limitation, you can monitor the position and adjust the take-profit and stop-loss orders as the price increases. By doing so, you can reach a point where the stop-loss will still lead to profits, even if the price continues to rise significantly.

Use Demo trading

A good risk management strategy in crypto trading is to use demo trading. If you’re new to trading or want to try a new strategy, demo trading is valuable. You’re trading on a live market using virtual (fake) funds when you practice demo trading. This allows you to test different trading ideas without risking your money. Once you’re confident in your strategy, you can start trading with real money.

Successful traders often use demo trading to test new strategies without risking real money. While some strategies may seem promising, they may need to work more effectively in practice. Demo trading is the best way to determine whether a new strategy is effective.

Please remember that when trading with fake money in a demo account, your perception of this money can differ from real market trading. This means you may be more willing to take risks when demo trading. However, once you move to the real market, it’s important to adjust your trading strategy and not view these funds as you did in the demo account.

FAQs on crypto trading risk management

How risky is crypto leverage trading?

Trading with leverage in cryptocurrencies is a high-risk strategy. Cryptocurrencies are volatile assets, and their price can fluctuate significantly in a short period. Using leverage can result in substantial losses if the price moves in the opposite direction of your trade.

However, it doesn’t mean that you should avoid using leverage when trading with cryptocurrencies. Instead, you should choose leverage carefully and trade an amount of money you can afford to lose without any significant impact on your life.

What is the biggest risk when trading cryptocurrencies?

Cryptocurrency trading is associated with a major risk: sudden fluctuations in the price of cryptocurrencies. These fluctuations can occur unpredictably and can lead to significant losses for traders. While a sudden price increase can be profitable, a sudden decrease causes most people to lose money. As cryptocurrencies are speculative assets and many crypto prices are interdependent, a single negative piece of news about a particular cryptocurrency, exchange, or network can significantly impact the market. As a result, prices can drop sharply without you realizing it. 

To limit this risk, you are advised to always include stop-loss orders in your trading system. Doing so can ensure that you suffer the maximum loss you are willing to bear. If the price drops beyond that point, your position will be automatically closed, limiting your losses.