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When trading crypto, it's important to be aware of the risks involved and take steps to manage them. By doing so, you can avoid losses and make more profitable trades. In this article, we cover the type of risks you can encounter when trading crypto and how to mitigate them effectively.
What are the type of risks in crypto trading?
Regulatory risk
Regulatory risk is the risk that a government will regulate crypto tokens in a way that reduces their value. This risk is especially high in countries where crypto is not yet regulated. Governments may decide to ban crypto trading, or they may regulate it so tightly that it becomes unprofitable to trade.
There are two main ways to reduce regulatory risk: diversifying your portfolio and staying informed about new regulations. By diversifying your portfolio, you can spread your risk across multiple crypto assets. This makes it less likely that any one regulation will cause a significant loss in value.
Staying informed about new regulations is also important. By knowing what the government is planning, you can adjust your trading strategy to account for the new regulations. This will help you avoid losses caused by regulatory changes.
Technology risk
Technology risk is the risk that a cryptocurrency will become obsolete.
Crypto technology is advancing at an incredible pace, and blockchains are becoming more efficient all the time. For example, the Bitcoin network uses Proof-of-work validation mechanism to process transactions. This allows for the network to process transactions with an average speed of 7 transactions per second. While that's a leap over the slow model of traditional finance, it is no competition for more efficient blockchains such as Solana. Solana is one of the fastest blockchains out there. Using a hybrid proof-of-history (PoH)/proof-of-stake (PoS) consensus mechanism it achieves a speed of 3,000 transactions per second (and could theoretically increase to 710,000TPS).
There is a lot of controversy about proof of work and its energy consumption impact on the environment, this could lead to a change in the crypto landscape.
To reduce technology risk, you should diversify your portfolio across multiple crypto assets. This way, even if one cryptocurrency becomes obsolete, your portfolio will not be significantly affected.
You should also keep up with the latest developments in crypto technology. By knowing what new technologies are being developed, you can make sure your portfolio includes crypto assets that are on the cutting edge. This will help you avoid losses caused by technology risk.
Custody risk
Custody risk is the risk that you will lose your crypto because you can't access them. This can happen if you forget your password, or if the company you're using to store your crypto goes out of business. You could also lose access to your crypto if you are storing them in a physical wallet and you lose it.
To avoid custody risk, you should use a reputable crypto custody service. Make sure to keep a backup of your passwords in case you lose access to them. You should also pay special attention to not accidentally throwing away or losing your physical crypto wallet (ask the guy who accidentally trashed 181M worth of bitcoin).
Exchange risk
Exchange risk is the risk that an exchange will close down or be hacked. This can result in you losing access to your crypto assets.
To avoid exchange risk, you should use a reputable exchange. You should also make sure to spread your portfolio across multiple exchanges.
Liquidity risk
Liquidity risk is the risk that you will not be able to sell your crypto asset at the price you want. This can be caused by low liquidity in the market or by large sell orders. While liquidity is rarely a concern for top market cap tokens, it can be a significant risk when trading small cap tokens.
To reduce liquidity risk, you need to understand the liquidity of the crypto asset you are trading. You can do this by looking at the order book and volume chart. The order book shows how much of a crypto asset is being offered for sale at different prices. The volume chart shows how much of a crypto asset has been traded in the last 24 hours.
Another way to reduce liquidity risk is to use limit orders. A limit order allows you to set a price at which you are willing to buy or sell crypto. This helps ensure that you will get the price you want, even if there is low liquidity in the market.
By understanding the liquidity of a crypto asset, you can know how easily it can be sold. If there is low liquidity in the market, you may have to sell at a discount or wait for a buyer to come along. If there are large sell orders, it may be difficult to find a buyer at the price you want. In both cases, liquidity risk can cause losses.
Volatility risk
Volatility risk is the risk that the price of a crypto asset will fluctuate rapidly. This can cause losses if you are not prepared for the price changes.
To reduce volatility risk, you need to understand the historical volatility of the crypto asset you are trading. You can do this by looking at a price chart. The price chart will show you how the price has fluctuated over time.
Leverage and liquidation risk
To reduce leverage risk, you need to understand how leverage works. Leverage is when you borrow money to invest in crypto. This increases your potential profits, but it also increases your potential losses. So, it's important to understand how much leverage you are using and to be aware of the risks involved.
If the price of the crypto asset moves against you, you may lose more money than you have invested. If the value of your crypto asset falls below a certain level there is a risk that your whole account balance will be liquidated. When this happens, the exchange will automatically sell your crypto asset to cover the loan.
Using leverage increases your risk significantly, so it's important to understand how it works. To reduce this risk, you should use a low amount of leverage or avoid using leverage altogether.
Risk management strategies
Position sizing
Position sizing is the process of allocating a fixed amount of capital to a specific trade. This limits your exposure to any one trade and helps you to stay in the market for the long term. It also allows you to make more trades, which increases your chances of making a profit. For example, a typical position sizing strategy is to use a 1% risk per trade. This means that if you have a $10,000 account, you would risk losing a maximum of $100 on each trade.
By using position sizing, you can reduce the impact of volatility on your account and spread out your risk over many trades.
Risk:Reward Ratio
The risk:reward ratio tells you how much you can expect to lose compared to how much you can expect to gain. The risk:reward ratio is calculated by dividing the potential loss by the potential gain. For example, if you think there is a 50% chance of losing $100 and a 50% chance of gaining $200, the risk:reward ratio would be 1:2 (1 divided by 2). This means that for every $1 you risked, you could potentially gain $2 back.
By using the risk:reward ratio, you can ensure that your risks are limited and that you're making a profit on every trade. It also allows you to maximize your profits by increasing your winning trades and reducing your losing trades.
Stop Loss and Take Profit
When trading crypto, it's important to use stop loss and take profit orders to limit your risk. Stop loss orders are used to sell a crypto asset if it falls below a certain price. This limits your losses and helps you to protect your capital. Take-profit orders are used to sell a crypto asset if it reaches a certain price. This locks in your profits and helps you to maximize your gains.
Incorporating good risk management into your trading strategies
Journaling your gains and losses
When trading crypto, it's important to keep a journal of your losses and gains. This helps you to track your progress and identify any problems with your trading strategy. It also allows you to see how well you're doing and whether you need to make any changes.
Monitor your win rate
Your win rate is the percentage of your trades that are profitable. For example, if you make 10 trades and 6 of them are profitable, your win rate would be 60%. It's important to monitor your win rate so you can identify any problems with your trading strategy. If your win rate is too low, it may be a sign that you're taking too much risk.
Measure drawdown
When trading crypto, it's important to measure your drawdown. Drawdown is the biggest loss you've ever had from your peak balance. It helps you to identify how much risk you're taking and whether your trading strategy is working. By measuring your drawdown, you can ensure that you're not taking too much risk.
