2 August 2023
Responsible trading and investing both require effective risk management. It can lower the overall risk of your portfolio in a number of ways, such as by implementing basic stop-loss and take-profit orders, hedging against financial events, or diversifying your investments.
For many traders and investors, reducing risk is a top concern. You will, in some manner, assess the risk of your investments against the payoff even if your risk tolerance is high. However, risk management involves more than just picking less hazardous trades or investments. There is a wide range of risk management tactics at your disposal, many of which are also appropriate for novices.
In order to reduce financial risks associated with your investments, risk management requires forecasting and detecting those risks. The risk exposure in their portfolios is then managed by investors using risk management tactics. Assessing your present risk exposure is an important first step before developing strategies and plans that are based on it.
Following the identification of investment hazards, traders and investors adopt plans and strategic measures known as risk management methods. The use of loss insurance and asset class diversification in your portfolio are just two examples of how these tactics might lower risk.
It's crucial to comprehend the fundamentals of risk management planning in addition to active risk management procedures. Before implementing a particular risk management approach, there are four main planning techniques you should think about because the method you select will influence your desired strategy.
Four essential risk management planning techniques
Acceptance: Making the decision to accept the risk involved in investing in an asset but refraining from spending money to mitigate it because the possible loss is small.
Transfer: Paying a fee to assign the risk of an investment to a third party.
Avoid: Steer clear of any investments in risky assets.
Reduction: By diversifying your portfolio, you can lessen the negative financial effects of a risky investment. This might apply to assets in the same asset class or even different sectors and types of assets.
It is well known that cryptocurrency is one of the riskier asset classes available to the average investor. Prices have shown to be erratic, projects have been known to fail overnight, and it can be difficult for newbies to comprehend the technology underlying blockchain.
Given how quickly the cryptocurrency market is developing, it is essential to use effective risk management techniques and methods to minimize your exposure to potential hazards. This is also a crucial phase in developing into a successful and ethical trader.
Discover five risk management tactics that can help your cryptocurrency portfolio as you continue reading.
The 1% rule is a straightforward risk management tactic that states that you should never risk more than 1% of your total capital on a trade or investment. There are a few options if you wish to follow the 1% rule and have $10,000 to invest.
One option would be to spend $10,000 on ETH, or any asset you like, and place a stop-limit or stop-loss order to sell at $9,900. In this case, 1% of your $100 investment capital would be the loss cutoff.
Without a stop-loss order, you could also buy $100 worth of XRP, as you would only lose 1% of your total investment if the price of XRP fell to zero. The 1% rule only influences how much you are willing to risk on an investment, not the magnitude of your investments.
The 1% rule is crucial for cryptocurrency users because of the market's turbulence. It's simple to become greedy, so some investors could put too much money into one investment and even suffer significant losses in the hope that their luck will change.
A stop-loss order establishes a specified price at which a position will end for an asset. When activated, the stop price, which is set below the current price, aids in preventing future losses. In contrast, a take-profit order establishes a price at which you want to close your position and lock in a particular profit.
Take-profit and stop-loss orders provide two different approaches to controlling your risk. They can first be prepared in advance and will be carried out automatically. You don't have to be available all the time, and if prices are very volatile, your pre-set orders will be executed. This enables you to set reasonable caps on the losses and gains you may accept.
Setting these boundaries in advance is preferable to doing it on the spot. Even though it may seem unusual to consider take-profit orders as a component of risk management, you should keep in mind that the longer you wait to take profits, the greater the chance the market will decline again as you wait for further gains.
One of the most well-known and essential strategies to lower your total investing risk is portfolio diversification. A diversified portfolio will not have too much exposure to any one asset or asset class, reducing the chance of suffering significant losses from a single asset or asset class. For instance, you might manage a range of coins and tokens, in addition to offering liquidity and loans.
Hedging is a little more sophisticated method of preventing losses or minimizing gains by acquiring another asset. These assets typically have inverse correlations. Although diversification can be a form of hedge, futures are probably the best-known example.
You can secure a price for an asset at a later time using a futures contract. Consider the scenario where you predict that the price of ETH will decline and seek to protect yourself from this risk by opening a futures contract to sell ETH for $20,000 in three months. Your future investment will pay off if the price of ETH drops to $15,000 in three months.
It's important to keep in mind that futures contracts are settled financially rather than requiring physical delivery of the coins. By hedging against the risk of ETH's price falling in this scenario, the party on the other side of your contract would pay you $5,000 (the difference between the spot price and the futures price).
As already established, the cryptocurrency market is unstable. However, there are still chances to apply hedging strategies and diversify within this asset class. In contrast to less volatile, more traditional financial markets, diversification is far more important in the world of cryptocurrencies.
A straightforward but efficient way to reduce the likelihood of suffering significant losses is to have an exit strategy. You can capture profits or cut losses at a predetermined point by adhering to the plan.
It's common for people to want to continue while they are earning gains or to have too much faith in a cryptocurrency even when its prices are decreasing. You can make bad decisions if you let hype, maximalism, or a trading community influence you.
Utilizing limit orders is one approach for carrying out an exit strategy effectively. Whether you want to take a profit or set a maximum loss, you may arrange for them to automatically trigger at your limit price.
For any investor, DYOR is an essential risk-reduction approach. It's simpler than ever to carry out your own study in the era of the Internet. You must conduct your due diligence before investing in a token, currency, project, or other asset. You must carefully examine a project's foundations, including its white paper, tokenomics, collaborations, roadmap, and community.
But false information travels quickly, and anyone may present their views as facts online. When conducting research, take into account the context in which the information is delivered and where you are acquiring it from. Shilling is widespread, and investors or projects can disseminate inaccurate, favoritistic, or promotional news as though it were sincere and accurate.
You'll have a useful toolkit with the five risk management techniques listed to assist lower the risk in your portfolio. You can invest more responsibly even by using straightforward strategies that address the majority of situations. On the other hand, it may be possible to develop risk management plans with more sophisticated, in-depth strategies.