Crypto Trading Risks Basics: Study All the Risks Before Trading

Types of risk

Although some countries require centralized exchanges to use KYC (Know Your Customer) and AML (Anti-Money Laundering), the modern crypto market is mostly uncontrolled by governments due to a lack of legislation. However, it can be affected by outside factors, such as political, social, or economic changes around the globe. This leads to market instability, and, as a result, trading risks. They can be divided into several categories:

Fraud risk

This risk applies to crypto projects. It occurs when one of the parties behind a project fails to fulfill its obligations. Usually, it has something to do with theft or fraud that goes against all crypto trading rules. As crypto is unregulated, it’s hard to hold people accountable for their misdeeds.

One of the most famous examples is the My Big Coin case. Created in 2013, it was announced as a new cryptocurrency, around which a whole ecosystem would appear in time. According to the plan, it was supposed to be like today’s Ethereum. In 2018, when over $6 million was invested in the project, the head of the project was arrested. It was announced that the whole project was a big long-term scam, in which investors' money was transferred to the scammer’s personal accounts, and then disappeared. As a result, investors never got their money back, and the project itself was dissolved.

Legal risk

This type of risk is associated with various laws and regulations targeted against crypto. Despite their influence on the modern market, some governments see it as a threat to national currencies. That’s why you can read in the news about bans on crypto trading or mining in China, or the UK’s ban of the Binance crypto exchange.

Someday, this situation might change, like in El Salvador, where Bitcoin became a legal tender, but another hindrance will likely appear instead: taxes for crypto traders.

Liquidity risk

Liquidity is an important indicator for all currencies, not only crypto. The more liquid a cryptocurrency, the easier it is to trade in and out of, and the easier it is for people to use on a daily basis. The liquidity risk in crypto trading is connected to the possible inability to convert a coin to any fiat currency or use coins to make purchases.

If a trader can’t use their funds during purchase or exchange processes, it means they are stuck with the useless coins they invested in. Of course, this is strongly connected to politics. If governments make cryptocurrencies legal, the liquidity of these cryptocurrencies will know no borders. 

Market risk

The crypto market crash in May 2021, during which the prices of cryptocurrencies decreased by 30% on average, showed that nobody is protected from market risk. Sometimes, the crypto market can change drastically due to unpredictable events (e.g., a new policy in the USA or China, or a tweet from Elon Musk). No matter what happens, any trader must be prepared for market risk, when changes in a coin’s price lead to the market’s rise or fall. That is why any trader must analyze the current and past price changes, and follow the current world news.

Operational risk

Keep in mind that cryptocurrencies are all about technology. They don’t have any physical structure or body. Most of them are just lines of computer code. Operational risk is about the inability of a trader to use their digital assets due to some software, network, or internet problems. 

One of the most common situations is when a trader takes part in trading, but can’t complete a transaction because of a bad internet connection, or, when an exchange is temporarily down due to too many traders flooding the system.

Main risk management strategies

Crypto trading is a business full of risks, but it’s in traders' best interest to learn how to avoid or at least mitigate them. This is where risk management strategies come in handy.

Trading risk management strategies help a trader analyze the market and possible trading risks. They are based on price changes, amounts of coins traded, and comparisons. There are three main approaches:

• Risk/Reward Ratio
• Position Sizing
• Stop Loss + Take Profit

One of the main rules of crypto trading goes, “Don’t risk more than you can afford to lose.” We don’t recommend traders to use more than 10% of their monthly revenue or budget. Still, this number must be chosen, based on your income and personal interests. Also, trading with borrowed money is not a good idea.

To calculate the amount of coins you are risking, or how much you may lose, use one of the strategies above. Let's take a look at each risk management strategy in detail.

Risk/reward ratio

The essence of this strategy is a comparison between the actual level of risk and the potential returns. Let’s try to understand it by using an example.

Imagine that you wish to determine the risk of bitcoin trading. First of all, you must use a formula to calculate the ratio:

R = (Target Price - Entry Price) / (Entry Price - Stop Loss)

Let’s say the prices are the following:

• Entry Price = $34,000
• Stop Loss = $30,000
• Target Price = $40,000

Using the formula, we have:

R = ($40.000 - $34.000) / ($34.000 - $30.000) = 1.5, or 1:1.5

The 1:1.5 ratio means that trading is not risky. You can start trading because you have a chance to gain extra profit. If you get a ratio lower than 1:1, it’s better to wait a bit and not trade right now.

Position sizing

Position sizing is a method that allows a trader to calculate risk per trade. Its goal is to calculate what amount of crypto coins or tokens a trader can safely buy. There are three ways to do that:

• Entry amount vs. risk amount

This method contains the formula to calculate the ideal amount of coins to invest in. Based on the entry price, risk per trade, capital for the trade, and stop loss, you should use this formula:

A = ((Capital for the trade * Risk per trade) / (Entry price - Stop loss)) * Entry price

Risk per trade can be calculated with a similar formula:

R = (Target Price – Entry Price) / (Entry Price – Stop Loss)

Let’s take a look at an example, where you want to purchase Bitcoin with USD with the target of $10.000, and:

• Capital for the trade = $5.000
• Risk per trade = 2.6% 
• Entry price = $6.000 
• Stop loss = $4.500

Your enter amount will be:

A = (($5.000 * 0.026) / ($6.000 - $4.500)) * $6.000 =$520

This means that the ideal investment in this deal is $520, or 10.4% of the total capital per trade.

• “Sharks and Piranhas“ calculation by Elder

This concept was created by professional trader Alexander Elder and meant to diversify one’s investments. Elder said that every position should be limited to a 2% risk. You can risk more, but this can be as destructive for you as a shark bite.

At the same time, limiting trading sessions to 6% per session is like a piranha attack. Sure, you may lose something, but in small amounts and in the long run.

Kelly criterion

Created by John Kelly 65 years ago, this method is suitable for long-term traders. Its main purpose is to define the percentage of capital to bet using this formula:

A = (Success % / Loss Ratio at Stop Loss) – ((1 - Success %) / Profit Ratio at Take Profit)

Here is an example of this formula, where:

• Success = 70%
• Loss ratio at stop loss = 1.30
• Profit ratio at take profit = 1.40

A = (0.7 / 1.30) - ((1 - 0.7) / 1.40) = 0.32

Such a result shows that you shouldn’t risk more than 32% of the capital you have.

Stop loss + take profit

These are orders, or commands, a trader makes when the price of some coin goes up or down to some specific point. Thus, with the former, you can avoid unprofitable deals, while the latter helps you close the deal before the market turns against you. Usually, traders use specific programs in order to get the signals they need. Some advanced programs can block or unblock the possibility of trading, depending on the price of a coin.

Tips to succeed

Now, it’s time to talk about some tips and advice that may help you not to lose your money. For you to figure out how to benefit from crypto market movement in crypto trading, you should first realize that:

• Losing is okay. You can’t win all the time, but, by accepting your own failures, you can learn and avoid some risks in the future.
• Analyze the past and the current state of the market. Analysis is a great tool that helps traders know exactly when and what cryptocurrency will rise in price (or not). The market and its every movement are cyclic. Knowing its patterns will help you measure the cycle and predict future events.
• Focus on your goal. Ask yourself why you trade and what you wish to achieve. Get a clear understanding of your trading purpose to avoid unnecessary risks and focus on what you have and what you need. A good example is crypto day trading, the rules of which allow users to speculate on the market. The goal is to get as much profit as possible in 24 hours. Thus, traders achieve their goals without paying attention to unnecessary details and all the risks associated with them.

Summary

Calculating potential trading risks helps you save your assets when trading. With time, you’ll become more experienced in this sphere and, with proper education, will be able to detect all possible outcomes, both negative and positive.