Five Risk Management Strategies

Risk management is a key part of responsible investing and trading. You can reduce the overall risk of your portfolio through various risk management methods such as diversification, hedging against financial events or executing simple stop loss and take profit orders.

Minimizing risk is a top priority for many investors and traders. Even if your risk tolerance is high, you still somehow weigh your investment risk and reward. However, risk management is not just about choosing less risky trades or investments, it involves a comprehensive set of risk management strategy tools, many of which are also suitable for beginners.

What is Risk Management?

Risk management entails anticipating and identifying financial risks associated with your investments in order to minimize them. Investors then employ risk management strategies to help manage their portfolio's risk exposure. A critical first step is to assess your current risk exposures and then develop a strategy and plan around those risks.

Risk management strategies refer to the plans and strategic actions that traders and investors implement after identifying investment risks. These strategies reduce risk and may involve substantial financial activities such as insuring against losses and diversifying a portfolio across different asset classes.

In addition to practicing proactive risk management practices, it is critical to understand the basics of risk management planning. Before embarking on a specific risk management strategy, you should consider the following four key risk management planning approaches that will inform your preferred strategy.

Four Key Risk Management Planning Approaches

Assumption: Deciding to take the risk of investing in an asset, but because the potential loss is not large, it does not pay the cost to avoid it.

Transfer: The transfer of investment risk to a third party for a fee.

Avoidance: Do not invest in potentially risky assets.

Reduce: Reduce potential losses on high-risk investments by diversifying your portfolio. The approach may be applied within the same asset class, or even across industries and asset classes.

Why are risk management strategies important in the world of cryptocurrency investing?

Cryptocurrency assets are notoriously one of the high-risk investment classes within the reach of ordinary investors. As it turns out, cryptocurrency prices are highly volatile, projects can collapse overnight, and the technology behind blockchain can be difficult for newcomers to understand.

With the rapid development of cryptocurrencies, it is imperative that investors employ sound risk management practices and strategies in order to reduce their own potential risk exposure. It is also a crucial step in becoming a responsible and successful trader.

Here are five risk management strategies that can benefit a cryptocurrency portfolio.

Strategy #1: Consider the 1% Rule

The 1% rule is a simple risk management strategy that requires an investment or transaction to risk no more than 1% of total capital. If you have $10,000 to invest and want to follow the 1% rule, here are a few ways to do it.

One is to buy $10,000 worth of Bitcoin (BTC) and place a stop or limit order to sell at $9,900. In this case, you can limit your loss to 1% of your total invested capital ($100).

Alternatively, you can buy $100 of Ether (ETH) without placing a stop loss order, so that even if the price of ETH drops to 0, you will only lose a maximum of 1% of your total capital. The 1% rule affects not the size of your investment, but the risk you are willing to take on an investment.

The 1% rule is especially important for cryptocurrency users due to the high volatility of the cryptocurrency market. It's easy to get greedy, and some investors can put too much money into an investment and even suffer huge losses in the hope that their luck will turn around.

Strategy #2: Setting Stop Loss and Take Profit Points

A stop loss order sets a predetermined price for an asset, and when the asset price reaches the predetermined price, it will trigger a liquidation operation. A stop loss is placed below the current price and, if triggered, will help prevent further losses. The operation mode of the take-profit order is just the opposite. It sets a predetermined price for an asset, and when the asset price reaches the predetermined price, it will trigger a liquidation operation to lock in a certain profit.

Stop loss and take profit orders help you manage risk in two ways. First, they can be pre-set and executed automatically. You don't need to keep an eye on the market 24/7, and if the asset price is highly volatile, your preset order will be triggered. Plus, you can set realistic limits on the losses and profits you can afford.

It's better to set these limits ahead of time than to set them on the spur of the moment. While it might seem strange to think of a take profit order as part of risk management, you should keep in mind that the longer you wait to take profit, the higher the risk that the market will fall again while it waits for further gains.

Strategy #3: Diversification and Hedging

Portfolio diversification is one of the most popular and fundamental tools for reducing your overall investment risk. A diversified portfolio minimizes the risk of significant losses in a particular asset or asset class by not being overly invested in any one asset or asset class. For example, you can hold a variety of different currencies and tokens, and you can also provide liquidity and loans.

Hedging is a more advanced strategy that protects gains or minimizes losses by buying another asset. These assets are usually negatively correlated. Diversification can be called a hedging strategy, but perhaps the best-known hedging strategy is futures.

You can lock in the price of an asset at a certain date in the future through a futures contract. For example, suppose you think the price of Bitcoin is going to plummet, so you decide to hedge against this risk and open a futures contract to sell Bitcoin for $20,000 within three months. If the price of Bitcoin does drop to $15,000 three months from now, you will make a profit on your futures position.

It is worth bearing in mind that futures contracts are financially settled and you do not need to physically deliver the tokens. In this case, your counterparty will pay you $5,000 (i.e. the difference between the spot price and the contract price), and you will be well hedged against the risk of falling Bitcoin prices.

As mentioned earlier, the cryptocurrency space is highly volatile. However, investors can still diversify within the asset class and take advantage of hedging opportunities. Diversification is even more critical in the cryptocurrency market than in the less volatile traditional financial markets.

Strategy #4: Be Prepared for an Exit Strategy

Developing an exit strategy is a simple and effective way to minimize the risk of significant loss. By sticking to an exit plan, you can realize profits or cut losses at predetermined points in time.

Oftentimes, it’s easy for investors to want to keep going when they’re taking profits, and it’s easy to put too much faith in cryptocurrencies when prices fall. Indulging in hype, maximalism, or the trading community can also interfere with your investment decisions.

One way to implement a successful exit strategy is to employ limit orders. Whether you want to take a profit or set a maximum loss, you can set limit orders to automatically trigger when the limit price you set is reached.

Strategy #5: Do Your Own Research (DYOR)

Doing your own research is an integral investment risk reduction strategy for any investor. In the internet age, it's easier than ever to do your own research. You must do your own due diligence before investing in a token, project or other asset. The key to due diligence is to look at the basic information of the project, such as the project white paper, token economics, partners, roadmap, community and other basic elements.

However, misinformation spreads quickly, and anyone can submit their views or data online. Therefore, when conducting research, it is important to consider the sources of your information and the context in which it is presented. Childcare scams are commonplace, and projects or investors may spread false, biased, or promotional news as if it were genuine, factual news.

Summarize

This article outlines five risk management strategies to provide you with an effective toolkit to help reduce risk in your portfolio. Even a simple approach that covers most areas can help you invest more responsibly. In addition, this article can help you develop risk management plans and more advanced and in-depth risk management strategies.