3 Key Concepts of Risk Management Every New Crypto Trader Should Know
In previous lessons from this “Beginner’s Guide to Trading Crypto“, you’ve learned how to use fundamental analysis to generate trade ideas, then you learned how to use technical analysis and price action to find a potential entry price for a trade.
There’s one more step needed before opening an actual position and exposing your capital to risk (of loss) and that is to figure out your trade management plan and risk management plan.
Capital preservation is the first priority of successful market speculation.
☝️ I can’t stress this enough.
And in order to preserve capital, you need to properly manage risk!
The best traders tend to cut losses quickly and let their winners ride. ✂️🏄
This principle alone is how we avoid terrible scenarios like letting winners turn into losers or letting one bad trade destroy an account completely.
Of course, “cutting losses quickly and letting the winners ride” is easier said than done, especially for discretionary traders who often have to weigh changes to fundamentals and broad market sentiment against price action (which sometimes do conflict).
Fortunately, trade and risk management (“TRM”) tools and tactics aren’t too difficult to understand
Three Key Concepts of Trade and Risk Management
The three key concepts to know before you get started are:
- Stop losses
- Position sizing
- Scaling
Let’s discuss each concept below.
What is a stop loss?
A stop loss is the part of your trade management plan where you decide to exit the position completely.
This could be based on either a price action signal, technical indicator signals, fundamental scenarios, or a mix of all three invalidating your trade thesis.
To learn more about how to use stop losses, read our lesson in our School of Pipsology, “What is a Stop Loss?”
What is position sizing?
Position sizing: is the amount of crypto that you will long or short, determined by both the maximum amount of value you are willing to lose if the trade goes bad, also known as “max risk“.
For beginners, the max risk should be more than 1% – 2% of your portfolio for short-term trades, and 5% on longer-term positions.
For example, let’s say you have a $1,000 crypto account and you want to buy a token with a market price of $10 per token.
You want to limit your max risk to 2% of your account (or $20) and your analysis shows that you should set a stop loss (i.e., close the position) if the token falls to the $5 price level.
Based on that setup, your position size, if you buy the token at $10, should be 4 units. A $5 drop in value of token x 4 tokens = -$20 loss (2% of $1000 account).
To learn more about position sizing, read our lesson in our School of Pipsology, “Position Sizing“.
What is scaling?
Determining the exact price or time of when the market direction (and/or volatility levels) will change is nearly impossible.
Unless you have a very high conviction of a price you want to enter at, it’s a good practice to break your entries and exits into two or more orders around your target entry/exit area.
Using the same example above from position sizing, let’s say you want to buy a token at $10 but your analysis says that it could dip to as low as $8 before sentiment turns completely bullish.
To reduce the odds of both setting your entry too low (and potentially missing out on the trade) or too high (potentially not getting in at the best price/reducing potential return), you should consider breaking up your entry/exit orders into different price levels.
Instead of buying 4 tokens at $10, you could consider buying one token at $10, one token at $9, and two tokens at $8.
This gets you into the trade with a partial position if the token does not dip past the $10 price level, and if it dips all the way to $8, then you actually scaled into a lower average price of $8.75.
And if you still use the $5 level as your max stop, then your max risk is lower at $15 of total account risk.
These are very simple examples, but understanding and practicing these concepts alone is likely enough to keep you out of major trouble in the beginning.
To learn more about position scaling, read our lesson in our School of Pipsology, “Scaling In And Out Of Positions“.
DO NOT USE LEVERAGE!
Leveraged trading is where you are able to open up a position size larger than the total capital put into the account.
This is either done through crypto centralized exchanges (CEXs) that offer margin trading, as well as some DeFi protocols that offer advanced borrowing mechanisms.
For example, let’s say you have $100 in your account, and you want to buy 1 unit of XYZ token at $100, which would create an open position worth $100.
A crypto exchange (CEX) offering margin trading may only require a 10% margin to open up a trade. In other words, you’ll only be required to open the position with $10, instead of having to put up the entire $100.
You now still have $90 “available” to open more positions if you’d like. This can be very tempting for many traders.
Considering a 10% margin requirement and a $100 account, you can open a position size of 10 XYZ tokens, which would have a notional value of $1000 ($100 x 10 units), and the CEX will set aside the $100 in your account as margin for the trades.
You are now leveraged 10x (which is considered an extremely high amount of leverage).
If the token gains 10% (position value grows from $1000 to $1100) in a short period of time, then you would DOUBLE your account value!
From $100 to $200 ($100 profit + the $100 in margin for the trade). Or if the token rises 20% to $1200, then you would TRIPLE your account to $300 in value!
That sounds amazing right!? It’s probably right about now that you’re calculating how long it would take before you can start buying lambos and flying private jets.
This is what a lot of traders think about when discovering the world of leveraged trading….how much money they could possibly make!
Well, I hate to burst bubbles but leverage is very much a double-edged sword, which means it can kill your account just as fast as it can grow it.
Let’s say the same position lost 5% (or -$50 off of the $1000 position starting value), then the trader just lost 50% of their $100 account!
Or worse, the $1000 notional position size goes down just 10% to $900 (or a -$100 loss)! At that point, the CEX will issue a margin call (ask the trader to deposit more money to keep the trades open), and if the trader can’t, then the CEX will close all positions, also known as “being liquidated”.
The CEX will use the $100 that it held for you as margin to cover your $100 loss. And since you only had $100 to start with, that means your account balance is now $0!
And because you’re broke, now you’re begging your mom to let you move back into your old room.
So, while yes, it is possible to make a lot of money really fast with leverage in crypto, you can lose a lot of money just as fast!
Considering that you’re a newbie trader, you’ll probably be terrible at all trading tasks.
What are the odds that you can pick the right direction and time the trade perfectly to avoid a complete account blow up within your first 10 leveraged trades? Or 20 leveraged trades?
If you answered “Almost zero percent!” then you would be correct!
Leverage can be a tool for some, mainly seasoned traders who have strict risk management practices.
It’s NOT for new traders who are going to be terrible at trading at the start. 😐
Summary
It’s a good idea to be conservative with how much risk you take and to only deploy capital to your very best trade ideas.
Here are some recommendations that every new crypto trader should consider:
- Limit your total exposure to the crypto sector to a small percentage of your total available liquid capital (i.e., cash, equities, and other liquid investments). Start off at 1% and grow from there.
- Limit your exposure to a specific crypto asset to a small percentage of your total crypto portfolio. Again, 1% – 2% max risk on short-term trades. Max 5% risk on longer-term positions.
- Use a stop loss with every position.
- Perfect timing is near impossible. Scale into trading positions or “dollar cost average” (DCA) into longer-term investments. Take profits along the way if a trade goes your way.
- DON’T USE LEVERAGE.
- Only put capital to work on your very best ideas (low-risk/high-reward setups on high-probability ideas).
- No position” is a perfectly fine position when you don’t see compelling opportunities.