A Beginner’s Guide to Risk Management
By Jelle - 07-Nov-2023
Trading is about taking risks, and profitable trading is about successfully managing those risks. Especially in crypto, risk management should consume more mental bandwidth of every trader than anything else. Drawing lines and boxes is easy. Writing tweets is easy. Having opinions and biases is easy. But managing risk – the actual work that every trader needs to be skilled at – is often the opposite of easy. But what is it?
Crypto Twitter is constantly tweeting about risk management, but sometimes the term seems nebulous to new traders. This article is written as a (mostly) comprehensive guide to risk management for novices. Risk management is important for all traders, not just noobs. But beginner traders often fail to account for being wrong, have no plan to manage risk, and end up having to improvise when a trade goes against them – a recipe for disaster.
What Is Risk Management?
Risk Management is the core responsibility of every trader to know when and how to minimise losses, maximise profits, and avoid blowing up a trading account, generally speaking. Good risk management can turn a “mostly wrong” trader into a profitable trader while the lack of risk management quickly turns a “usually right” analyst into homeless (jk).
For example, from a statistical perspective, a trader with an 80% win rate can still blow up their trading account and lose everything. A trader with a 40% win rate, on the other hand, can still be extremely profitable. Managing risk is the difference between these two traders.
At its most basic level, risk management is the process of a trader developing their rules for a systematic approach to managing trade size, duration, profits, losses, etc.
Practical Steps to Risk Management
In practice, risk management usually involves a couple of these common safeguards.
- Risk a limited amount of capital per trade.
- Diversify investments across different assets.
- Set stop-loss orders to limit potential losses.
- Identify a take-profit level before opening a trade.
- Know when to stop trading during a losing streak.
Using these risk management tools (or a selection of these tools) is essential to minimise losses and to increase the likelihood that a trading strategy remains profitable over time. Losses are inevitable for every trader, but the goal of managing risk is to make more than is lost.
Note: Crypto Cred has produced a free 69-minute video on risk management that is worth watching for even more detail on how to think about managing risk as a crypto trader.
Building Risk Management Rules
Each basic component of risk management listed in the previous section of this article plays into a few questions I use whenever I help someone build their own approach to managing risk.
- How much money should you risk per trade?
- How much money should you trade with?
- What is your win rate?
The rest of this article explains how to answer each question.
How much money should you risk?
Every trader needs to decide the maximum amount of money they are willing to risk losing per trade before entering a trade. This is crucial for the psychological aspect of being able to stomach a loss and moving on, but it is also important from a statistical aspect that ensures losses can be suffered without blowing an account.
So, how much money is enough? Risking next to nothing drastically reduces potential losses, but it also mentally disengages a trader from the battle of trading a market. Bet something that makes the trade worth the time to plan, execute, and manage. But don’t bet so much that if the trade ends in a loss, there is no possibility for taking another trade because the account zeroed out.
When managing risk, every trader needs to think about making it to the next trade – win or lose.
Many traders commonly limit their risk per trade to a single percent of their total trading portfolio. Doing this prevents even an extended losing streak from causing too much damage. But sometimes there are situations that suggest the reward is worth risking greater than 1% of an account. Other times, risking even less than 1% may be appropriate.
How much money should you trade with?
Deciding how much money to put into a trading account is another basic but essential question for every trader to answer. It seems simple but sometimes the answer is difficult to produce.
At a minimum, traders should fund their account with enough money to make trading worth their time. If this is not feasible for a prospective trader, they may be better off waiting until they have accumulated a minimum amount of money to fund the account.
Depositing someone’s entire life savings into a trading account, however, is absolutely inadvisable. Especially in crypto, part of risk management includes the counterparty risks inherent to wallets, exchanges, and other tools for managing and storing funds.
Using the 1% rule discussed above, answering this question can come from simple arithmetic by considering, “If I risk 1% per trade, what amount would represent 100% of that account?” For example, an account with $3,000 and a rule of 1% risk per trade would result in $30 trades. If that amount is not worth the time for a trader to spend participating in the market, consider adjusting these parameters of a risk management system.
What is your win rate?
Win rates are important to proper risk management but calculating the appropriate level of risk to take based on potential wins or losses. The risk (often called “R”) in a trade is part of the risk-reward ratio (RR). A trade’s risk-reward ratio should ensure profitability over a period of many subsequent trades by making sure that winning trades make up for the money lost in a bad trade.
A “2R” trade, for example, means the trader is risking half as much as they expect to profit. The bigger a trader’s wins are, which often relates to higher “R” trades, the more profitable their strategy will be. The table below helps visualize the relationship between risk-reward ratios and profitability.
Different strategies will have different win rates, and a trader’s win rates will certainly vary over time. This means it is important to adjust risk-reward ratios through different periods of profitability or losses. During win streaks, it may be okay to risk more than usual for a trade. During losing streaks, risking less may be appropriate until closing a few profitable trades and breaking the streak.
Always Be Managing Risk
Hopefully this article shows that risk management is not just a catch phrase that traders write about on Twitter. It is an essential component of profitable trading. By consistently taking trades sized according to their risk tolerance and with a risk-reward ratio that matches their current win-rate, their chances of success – despite a few inevitable losses – will skyrocket.
Risk management ensures survival which leads to long-term profitability. Tracking account history data using tools like Coin Market Manager, adjusting risk management rules based on recent performance, and sticking to those rules religiously are the key ingredients for proper risk management and profitable trading.