Trading

Crypto Trading Risk Management Guide

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CRYPTO TRADING RISK MANAGEMENT GUIDE

By Cryptol0gy

Let me ask you a question- You see two slot machines in front of you.

  • Slot machine 1: has an average 1:50 win/loss ratio every time you pull it.
  • Slot machine 2: has an average 1:70 win/loss ratio every time you pull it.

Which slot machine would you play? The first one of course, because you’d win more often. Here’s the problem: sometimes the slot machine 2 will win, and the slot machine 1 will lose. And that’s how trading works as well; you might do all the right things and still lose.

Sometimes you’ll get lucky, especially in a bull market. You’ll make massive profits by doing totally random things without any education or deep analysis behind each decision. But don’t get confused. That doesn’t mean that you should ever play the 1:70 machine. You’re still better off playing the 1:50 machine, even when it’s losing. The point is that you can do the right thing, and still not get what you want.

The real question becomes, what happens if you let go of all your convictions, cognitive biases, and ego traps; what do you actually do instead?

Today’s article is going to be one of the most important pieces of text you’ll ever read. If you don’t — truly — have this down, you won’t be around for too long in this space. If you apply the proper crypto trading risk management strategies, I can almost guarantee you’ll never blow up another trading stack — and you‘ll be on the path to becoming a real high-profit trader.

Protecting Your Capital Must Be Your First Priority.

In speculative trading, protecting your capital is more important than generating lots of profits. Even the best signals in the world will blow up your stack and send you home in the milk train if you don’t use a proper money management strategy. That’s the bad news. On the bright side, after you’ve spent 7 minutes reading this article, you’ll know exactly how to properly manage your risk in Crypto trading.

We’ve seen hundreds of Crypto traders who got off to a fantastic start with technical analysis, but who lost almost all of their money and quit, simply because of their lack of risk management. And that’s normal because when you first start trading, your first thought is “how much profit can I make from this trade?”

Massive fast potential profits are tempting, but as a professional crypto trader protecting your capital must be your first priority. — Shyam Shankar

Market cycles always keep going, and there will be times when the price action of the market will lead to a series of losing trades. If your goal is to make massive profits long-term, you must apply the risk management strategies to increase the probability of you becoming a high-profit trader. This article is dedicated to highlighting the pitfalls that you are likely to face as a crypto trader, and the steps you must take to avoid them.

Position Sizing

Never Risk More Than 1% of Your Trading Account

We suggest that you should never risk more than 1% of your trading account per trade. What’s the reasoning behind that? If you limit your risk on each trade to 1% of your trading account, you will almost guarantee long-term sustainability.

 

Even if you get very unlucky and lose 20 trades in a row, you’ll still have roughly 80% of your initial balance. Small setbacks like this can be made back with a couple of profitable trades, and new highs may be achieved again. In addition to this, during the losing streaks, the risk on each trade becomes progressively smaller and smaller. This will, in turn, form a reverse compounding effect.

In the previous article, you saw how consistent profits become progressively larger due to compounding. The opposite is also true. When you’re experiencing a losing streak, your losses will progressively get smaller. Risking a fixed percentage per trade makes sure that your stack uses the power of compounding on the way up, while simultaneously taking advantage of the reverse compounding when going down.

 

Risk/Reward Ratio

Before entering a trade, you must know the risk/reward ratio, or you’ll end up doing risky trades and eventually lose your money. This ratio shows you the expected return on a specific trade compared to the undertaken risk.

The lower the ratio is, the riskier the trade. Manually you can calculate your risk/reward with this formula: (Target — Entry)/(Entry — Stop Loss) If you want to be efficient and save time, use the Long Position or Short Position tools in Trading View to check your risk/reward ratio:

 

Simplified cheat sheet:

1:1 and Lower = Never trade

1:1 = OK

1:2 = Great

1:3 and Higher = Ideal

 

Let’s take look at a trading example:

Pair: BTC/USD

Direction: Long

Entry Price: $9350

Target Price: $10000

Initial Stop Loss: $9193

Risk/Reward: 1:4.14

Risk Per Trade: 1%

 

Know How Much You Are Risking

The question then becomes, how much money do you put on the trade? A beginner often selects a number such as $3,000, 0.3 BTC, or 15% of their stack.

Instead of this, calculate how much you can afford to lose on each trade. If your account size is $30,000 and your strategy is to risk 1% per trade, don’t risk losing more than $300 per trade. An easy way to calculate your maximum risk is with this simple equation: Account Size / 100 = Your maximum $ risk.

This is where people often get confused. This doesn’t mean that the position you enter the trade with is going to be $300. Instead, what it simply means is that your position size is such that if your trade hits stop loss, you’ll lose $300. For example, if the size of your trading stack is $30,000, you can risk $30,000/100=$300 per trade. So let’s get back to the trade. You had an order to enter this trade at $9350. Let’s imagine the price decides to turn down and hits your stop loss at $9193. To calculate your position size effectively, you must also calculate the maximum pip risk.

What is Pip? Pip is simply the price movement.

If the price moved from 100 to 101, the pip is 1. Pip = Price movement The maximum risk in pip movements on any trade can be calculated with the distance between the entry price and the stop loss price. Maximum pip risk = Entry price — Stop loss price $9350–$9193 = $157 In this example, the maximum amount of pips you can lose is 157. If your trade hits stop loss, you’ll lose 157 pips. You also chose to risk $300 on the trade. Therefore, your trade must be sized so that each pip is worth $1.91. Pip value required for trade = Dollar risk / Pip risk $300/157= $1.91 Per pip If you had correctly chosen a trade size that exposed you to only a $1.91 risk per pip, you’d take a loss of $300, which is only 1% of your $30,000 account.

How To Calculate Your Position Size

If you want a quick hack, here’s a formula you can use:

((Size of your stack * Risk % per trade) / (Entry Price — Stop Loss)) * Entry Price.

Let’s use the same example again:

EXAMPLE 1:

Pair: BTC/USD

Direction: Long

Entry Price: $9350

Target Price: $10000

Initial Stop Loss: $9193

Stack Size: $5000

Risk Per Trade: 1%

=(($5000*0.01)/($9350–$9193))*$9350 =$2978

That may be a surprise. $2978 position from a $5000 stack, that’s over 50% of the stack. But the truth is, if stop loss hits, you’ll simply lose 1% ($50) of your stack.

Here’s how: $9193 / $9350 = 0.9832 0.9832 * $2978 = $2928 $2978 – $2928 = $50

 

EXAMPLE 2:

Pair: BTC/USD

Direction: Long

Entry Price: $9350

Target Price: $10000

Initial Stop Loss: $8650

Stack Size: $5000

Risk Per Trade: 1%

In this example, stop loss is drastically lower compared to the first example. Let’s see how that affects our position size:

=(($5000*0.01)/($9350–$8650))*$9350 =$668

Now that our stop loss is much lower, our position size is radically smaller from the first example to maintain our loss at 1%, if stop loss hits.

 

Always Use Stop Loss Orders

A stop loss is an order placed on your exchange that closes a trade if it moves against you and reaches a certain price level. The stop loss is meant to stop any loss after a certain point. Each and every time you place a trade in the exchange, you must also have a stop loss either on an alarm or a set order on the exchange. This way, if the market moves against your position, it can only move down to a certain point, after which the trade is closed for a small loss. High-Profit crypto traders always set stop losses at the levels which invalidate the original trade idea. When a stop loss is hit, a high-profit trader doesn’t feel emotionally overwhelmed to win the money back. The majority of traders view being stopped out as a horrible thing. Losses are inevitable, and you must get comfortable with them. Pro tip: A great trade isn’t always profitable, and a bad trade isn’t always unprofitable. Now you’ve learned the three most important risk management tools. Just by implementing this, you’ll get very far. A short recap: Enter your trades with a proper position size. Never risk more than 1% of your capital. Always know and assess your risk/reward ratio. Always use stop losses. Now, let’s take a close look at what might happen if you don’t implement these strategies.

Drawdown Risk

Consider this example: Let’s say you have a $30,000 account and you lose $10,000. What percentage of your account have you lost? The answer is 33.33%. Simple enough. This is called drawdown.

A drawdown is the reduction in your capital after a series of losing trades. How to calculate your drawdown? Take your capital amount at its peak and minus the low.

 

Losing Streaks

You’re trading because you’re looking for an edge. Trading signals that are 80% profitable likely sounds like an excellent edge to have. But, did you know that just because your signals are 80% profitable, it doesn’t mean that you will win 8 trades out of every 10? You could lose the first 10 trades in a row, win the next 30 trades, and lose another 10 trades.

You really never know which one of these trades will be profitable. You would still have an 80% profitable system, but would you still be trading after losing the first 10 trades in a row without proper risk management? Exactly, you wouldn’t because you would have close to zero money left to trade with. That’s why having a risk management strategy is the most important aspect of trading.

No matter how good you’re at drawing charts, you will eventually have a losing streak. If you start with a $30,000 account and take a loss of 5%, your account value will fall to $28,500. This is also referred to as taking a 5% drawdown. Now, if you make a profit of 5%, you will make $1425. This only brings the account back up to $29,925. You’re $75 short. This can seem insignificant, but as the drawdown percentage increases, it becomes extremely harder to recover losses.

For example, it may not seem like much if you lose 1% of your trading account, as it only needs an increase of 1.01% to recover to its previously held position. However, a drawdown of 20% requires a 25% return, while a 50% drawdown requires a massive 100% increase in profits to recover to the same balance. The bigger your losses, the exponentially harder it will be to recover. That is the main reason we always limit our losses at 1%. If you’re in a situation where you lose 50% of your account, you’ll have to double your money just to get back to your original point.

 

Drawdowns Are Normal

For you to become a high-profit trader, you must create a trading strategy that will enable you to withstand these periods of losses. Part of your trading plan is the risk management strategy. If you practice these money management strategies with patience and discipline the reward will be amazing. Periods of prolonged drawdown periods will occur at some point in your trading career. To think otherwise would be irrational.

Even the best hedge fund managers, and investors on earth post entire years of drawdowns in a row. It’s easy to let greed creep up on you after three winning trades, and try to seize an opportunity by risking too much on a single trade. You can get badly hurt, and repeating this behaviour might even lead to you quitting trading completely. Remember, consistent profits will take you much further in life than gambling. If you master these principles in your trading, you’ll get very far in life.

 

Conclusion

When we were growing up, a lot of us were taught things like: “find a stable job, and save a 10% of your income to your savings account”. If you’re looking to stay broke for the next 30 years, and work for someone else, then yes. That’s precisely what you should do. You save that 10% and keep on working. However, if you’re looking to live a financially independent life, spoil your family with luxurious trips, and if you’re simply a person like me who likes to buy expensive things, then you need to do something completely different. You have to invest your money. But in an entirely different way. Here’s the truth. The people who make the most money aren’t always the smartest ones, or the ones who work the most hours. They are the ones who have the right skill set in the right market. They’re the most adaptable ones. If you’re not making as much money as you want, then you have to ask yourself: “Do I have the right skills? And am I in the right market? Am I doing the right things?” If the answer is no, then you’ve found the reason. All you need to do is get the right skills, be in a better market, and do the right things. Now if you’re looking to make massive profits, I would suggest you first get down the skills of High-Profit Trading.

Article written by Cryptol0gy

Follow Cryptol0gy on Twitter for news and updates.

This article was originally published on Cryptol0gy’s Medium page

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