Risk management is a skill that will differentiate gamblers from professionals.
Some investors can make a windfall by taking a substantial leveraged position and lose all of it twice as fast when the market turns against them. It’s not about where the market is going or what conditions are there, but about knowing how to limit your losses and increase your profits. You cannot skip the part about cutting your losses short and jump right into making profits. It does not work that way.
Investing is based on sound risk-taking, and before you know how to do that, there is no point in talking about being a profitable trader. It typically takes under a year for an average newbie to learn that, as around 70%-80% of traders lose all of their equity within the first year of crypto trading. That is a powerful lesson about poor risk management, yet if learned well, one can become a pro trader who losses little when the trades turn south and makes a lot when he makes the right decision. So, let’s jump into the basics of risk management right away.
Plan your trades and trade your plan
That is another cliche often used by traders. You simply cannot win at the game of trading without careful planning. You need to spend some time to figure out what strategy you will use for specific market conditions: trend, range, choppy markets. Similarly, how often you are going to trade. Some trade once or twice per year, others once or twice per week, others every day, yet others ten or more times per day. What kind of trader are you? Your plan should reflect those things.
What techniques and tools do you use in trading? Is it moving averages, trendlines, chart patterns, candlestick patterns, or a mixture of indicators? Or maybe you won’t use any technical indicators and rely on support and resistance lines to identify your entries.
Your plan should also indicate when you will enter the market (what conditions have to be there for you to open a trade), where you will place your stop loss, and where you will take your profits. Sounds like a lot of things to have in mind? The more prepared you are, the easier it will be for you to make decisions. The smaller losses you will incur, the greater your profits will be.
You can expand on your plan and make it 10 or more pages long; just be sure to make it as simple as possible and as easy to understand and follow as possible.
1%-2% rule to cut your losses short
There are various strategies for limiting your losses, yet the best one is probably to decide on the percentage of your equity you are willing to risk on each trade. Seasoned pros will tell you that you should never risk more than 1% or 2% or any single trade. It may seem very little, but if you experience a losing streak when you have to take a loss on 10 trades in a row (which happens to everybody), that will no longer seem like a slight loss.
So, if you are a very active trader, you should not risk more than 1% on any single trade, and if you are a long-term trader who trades swings and trends, you can use a 2% rule for cutting your losses short.
Check out how fast you would have got a margin call in a losing streak had you risked 10%, 5%, 2%, and 1% of your initial equity on a single trade. It is just an example, but it gives you a perspective on how fast things can turn south if you take too much risk on a single trade.
| Percentage of equity risked on a single trade | Number of losing trades before a margin call |
| 10% | 10 |
| 5% | 20 |
| 2% | 50 |
| 1% | 100 |
Use limit stop-loss and take profit orders
You can enter and exit the crypto market manually or automate your trading using automatic stop-loss and take-profit orders. What does that mean? It means that if you enter BTC/USD at $40,000, put your stop-loss at $39,000, and your take profit at $45,000, your orders will be automatically executed if one of the price levels is hit first. If, after buying the pair at $40,000, the price drops to $39,000, your trade is automatically closed.
These automatic orders are good because you might not be at your computer when the market starts dropping or rising dramatically. However, if the price increases to $45,000, your take profit order is triggered, and you can enjoy the profit you generate on $5,000. However, if you don’t have the orders in place, you will incur more significant losses than you anticipated or fail to lock in profits when the market reaches your pre-defined take-profit zone.
Keep your emotions in check
Although we humans are intellectual beings, we often allow ourselves to be misguided by our emotions. In relationships, emotions can often work in our favor; they hardly ever do in trading. The most common ones, such as fear and greed, can quickly derail your efforts to stick to your plan.
The issue with following your emotions is that you become reactive instead of being proactive, which is essential in trading. You need to anticipate what happens in the markets and plan what to do when the things you expect happen.
Emotions cause you to behave in reverse. When you have to let your profits run, you get scared the price will turn around, and you sell while the market continues to rally. Similarly, when the price is going down, you need to close your losing trade and not keep on hoping the market will reverse. Unfortunately, it hardly ever happens, and so the losses compile.
Do not forget that leverage is a two-edged sword
Leverage enables you to operate with much bigger funds than you have. For example, 1:5 leverage gives you an extra 5$ for every 1$ that you have. So, if you open a $1,000 position with a 1:5 leverage, you actually open a $5,000 position, five times bigger than your initial one.
On the one hand, you can make much bigger profits. On the other hand, you risk much more than trading without leverage. So, you can both win big and lose big very fast. A 1:5 leverage will cause you to both increase and lose your capital five times faster. If you are a risk-averse trader, you’d better be careful how you use leverage. You can even decide to trade without it and rely just on your own pledged capital.
Final thoughts
Risk management is the cornerstone of successful trading strategy. Before you learn how to make profits, you need to know how to protect your equity and reduce your risk before you even open a position. Once you have mastered that, you are well on your way to increasing your profits.
For information purposes only. Not investment or financial advice. Seek professional advice. Digital assets involve risk. Do your own research.
