How to manage risk as a cryptocurrency trader

As a trader in the crypto market, risk management is the single most important skill to develop. We’ve all heard the phrase “90% of traders lose money”. While this statement may be true, it’s important to realize that this happens primarily because most people trade with no risk management whatsoever.

Without the necessary knowledge about how to manage risk, there is a very good chance you will experience significant losses. In this post, we’ll go over a few basic risk management techniques that you can apply to your own strategy to make trading safer and more rewarding. Our aim here is to show you how to trade cryptocurrency safely.

Stop market vs trailing stop orders

The Liquid trading platform supports two kinds of stop loss orders: “stop market” and “trailing stop”:

• A stop market order automatically executes a buy or sell order when a specific price is reached.
• A trailing stop will intelligently follow price action and automatically execute a market buy or sell order when price drops or rises past a specific percentage or fixed currency amount threshold.

Let’s take a look at how stop market orders and trailing stops can be used in real life.

Stop Market

John opens a 10 ETH long position at USD200/ETH on Liquid with a risk tolerance of 2%. To manage his risk, John sets a stop market sell order at USD196. This means Liquid will automatically execute a market sell order if the price of ETH reaches USD196.

This guarantees John will only lose USD40 if the market moves against his trade. On Liquid, using stop orders in Net-Out Mode will cancel out exiting positions. In John’s case, setting a 10 ETH stop market sell order at USD196 will completely cancel out John’s initial order if the stop price is hit.

A stop market order also works the opposite way for short positions as well. If John opens a 10 ETH short position at USD200/ETH, he can set a stop market buy order at USD204 to maintain his 2% risk tolerance. In this situation, Liquid would execute a market buy order if the price of ETH reaches USD204.

Trailing stop

Jane thinks the price of Bitcoin is going to increase, so she buys in. However, Jane is anxious that the price can fall at any time. To prevent large losses, she sets a trailing stop on Liquid with a distance of USD50.

The trailing stop will follow the price of Bitcoin as it goes up, but if it goes down more than USD50 the spot will execute and Jane's Bitcoin will be sold. She will have successfully mitigated risk. 

Trailing stops are useful for riding the market, but it’s important to set a trailing percentage that gives room for your trade to breathe. 

Cryptocurrency markets move very fast. Next time you have to step away from a trade for an extended period of time, consider using a trailing stop to lock in potential profits.

Stop loss vs position size

The question of where exactly to put a stop loss order is entirely up to your personal risk tolerance. As a general rule of thumb, most experienced traders are willing to risk 1-3% of their capital.

Risking any more than that could potentially drain your account very quickly. In normal spot trading, calculating a stop loss price is straightforward. Let’s say Tom has a USD5,000 account on Liquid. He decides to buy USD2,000 worth of ETH (10 ETH at USD200/ETH). Tom has a risk tolerance of 2%, which means he’s willing to risk USD100 (2% of USD5,000) on this trade. Thus, Tom sets his stop loss at $190, which is a 5% drop in the price of ETH.

The important thing to keep in mind here is the relationship between position size and stop loss price. Since Tom did not use his whole account balance to enter the trade, he is able to risk a 5% drop in the price of ETH to let the trade develop before hitting his 2% risk tolerance on his capital.

If Tom had entered a USD5,000 position (25 ETH at USD200/ETH), he would’ve had to set his stop loss price at USD196, a 2% drop from USD200. Profitable trading is all about finding a good balance between minimizing risk while giving room for price action to develop. As we all know, crypto is an extremely volatile market. By managing his position size, Tom was able to give himself the necessary buffer for the usual market volatility to play out.

A margin trading example

Things get a bit more complicated in leveraged margin trading. Liquid offers up to 25x leverage, which essentially means you have up to USD25 of buying power for every USD1 of deposited margin capital in your account. This is accomplished through a system of asset lenders and liquidation rules. Let’s consider another trading example similar to the one above, but this time in the context of margin trading.

Hiromi has a USD1,000 in deposited margin capital on Liquid. She opens a USD5,000 XRP long position (10,000 XRP at USD0.50/XRP) with 10x leverage. This allows her to leverage USD5,000 in buying power with only USD500 of her USD1,000 deposited margin. Upon execution of her order, Hiromi’s margin coverage (available equity/required margin) is at 200%.

On Liquid, margin calls happen at 120% margin coverage, and forced liquidations happen at 110% margin coverage. For this position, Hiromi’s margin call price is USD0.46, which is approximately 8% away from her entry price. Like Tom, Hiromi is also willing to risk 2% of her capital or USD20 on this trade. At 10x leverage, this corresponds to a USD200 drop in available equity, meaning Hiromi’s stop loss should be set at USD0.48 to avoid losing more than 2% of her capital.

Now let’s talk about how lack of a position size management can quickly lead to a margin call followed by a forced liquidation. Once again, Hiromi has USD1000 of capital and opens a long position on XRP with 10x leverage, but this time she feels the FOMO. Instead of opening a reasonable USD5000 position, she uses USD750 of her capital to open a USD7,500 position (15,000 XRP at USD0.50/XRP). Like before, she is willing to risk 2% or USD20 of her capital on this trade.

In this situation, a USD200 drop in available equity corresponds with an XRP price of approximately USD0.4867. So, this is where Hiromi should set her stop loss, right? Not quite. Remember this is leveraged trading, which means margin calls happen at 120% coverage and liquidations happen at 110% coverage.

At USD0.4867/XRP, Hiromi’s margin coverage would already be at 106.73%, so it doesn’t matter if she sets her stop loss there because she would already be liquidated if XRP moves down to that price.

This is an example of how using a wrong position size can completely render your risk management pointless. The moral of the story is to always calculate a suitable position size that works within the boundaries of your risk tolerance.

In Hiromi’s case, a $5,000 position size would put her stop loss 4% above her margin call price, and that’s perfectly fine. However, increasing her position size to USD7,500 would effectively put her liquidation price above her stop loss, and that’s just gambling.

Strategy-specific stop loss placement

As you learn more advanced trading strategies over time, you’ll develop stop loss techniques that work in the context of a specific strategy.

For example, Joseph is a trader who primarily uses Elliott Wave Theory to find entries and exits. He enters a long position after Wave 3 breaks the high of Wave 1, as shown by the green box in the image below. Since this strategy relies on proper Elliott Wave formations, Joseph places his stop loss under the low of Wave 2 as depicted by the red box.

In this example, EMA trader Mark looks for clear rejections in the area between the 20- and 40-day moving averages to enter short positions, as shown by the green boxes. If the asset, in this case XRP, experiences sudden bullish movement to a few percentage points above the 40-day EMA, Mark’s stop loss is triggered, as depicted by the red box.

Conclusion

After reading this post, you should have a better understanding of how to manage your risk by knowing your personal risk tolerance and maintaining reasonable position sizes. In the future, we’ll build on the concepts introduced in this post and discuss how to manage risk when using more advanced trading strategies.