The risks of trading cryptocurrencies are mainly related to the volatility of the cryptocurrency market. As they represent a high risk, it is important that you understand the risks before starting an investment in cryptocurrencies. All financial assets carry high risk, whether through the use of leverage, unethical trading techniques or market volatility. Here is a list of the most common risks associated with investing in cryptocurrencies.
- They are volatile: unexpected changes in market sentiment can cause sudden and sharp price fluctuations. It is not uncommon for the value of cryptocurrencies to suffer sudden drops of hundreds, even thousands of dollars.
- Unregulated: Cryptocurrencies are currently not regulated by governments or central banks. However, they have recently been attracting some attention. For example, there are doubts as to whether they should be classified as commodities or as virtual currencies.
- The networks over which transactions take place are susceptible to cyber attacks: there are no perfect ways to avoid technical failures, human error or cyber attacks.
- They may be affected by forks or disruptions: trading cryptocurrencies involves additional risks, such as hard forks and disruptions. You should familiarize yourself with these risks before trading these products. In the case of hard forks there can be significant price volatility and we may suspend trading at these times if we do not have reliable underlying market prices.
We will attempt to alert you to potential blockchain hard forks. However, it is ultimately your responsibility to make sure you find out when these events might occur.
Cryptocurrency trading seduces, year after year, more and more people who believe they can generate millionaire profits with a few operations. However, greed can blind traders and make them make mistakes that put their capital at risk. When investing money, there is always a chance of losing it.
It is necessary for anyone who decides to invest in a cryptocurrency or trade in markets such as bitcoin to be very clear about how much money they really want to risk in order to receive a specific return. To do this, some professional investors and traders make use of risk management strategies that decrease potential losses in the face of a market setback.
In this article we will explore some of the common risks and mistakes that cryptocurrency traders make. We will also delve into several of the key concepts that will help us safeguard our capital and maximize profits.
Risks when trading in markets like bitcoin
To understand the need to be cautious when trading cryptocurrencies, it is essential to keep in mind the risks involved in trading these assets. The market is not always in favor of our strategy and it may happen that in a change of trend we lose money.
Volatility is one of the most outstanding characteristics of cryptocurrency markets. Although it is an element used by traders to generate profits, the instability of cryptocurrency prices can play against the trader’s profit expectations.
Emotionality in trading is also a setback. Some traders may invest more with their heart than with their head, insisting on a failed strategy, not recognizing that they were wrong in their predictions. Also, the cryptocurrency market has periods of excessive speculation and greed among traders. Less experienced traders are influenced by FOMO, investing more money than they are willing to lose.
If traders fail to trade their money with a certain objectivity, then they are more likely to lose money. Expectations that an asset will rise in price, without being based on the conclusions of a previous technical or fundamental analysis, are like gambling in a casino. Because of this, one of the most lethal risks in trading in general are the traders themselves and their unrealistic forecasts.
What is risk management?
You should make sure you fully understand the risks of cryptocurrencies before you start trading. Only invest if you are an experienced investor and have advanced knowledge of the financial markets. Investing in cryptocurrencies may not be appropriate for all investors.
Risk management, also known as “risk management”, is a discipline whose objective is focused on reducing the chances of a possible monetary loss. It is a methodology that can be applied in various business sectors, such as cryptocurrency trading, as it helps to plan actions in advance in order to protect traders’ capital and prevent losses from getting out of control.
The main idea of risk management is that the elements that endanger a trader’s capital can be identified and managed. In this way, a trader can prepare for unfavorable price fluctuations for his trading strategy and secure his opportunities to make money. This is achieved by planning based on the trader’s expectations for each of his trades, using indicators such as support and resistance levels as a reference, and relying on orders such as stop loss (S/L) or calculations such as risk per trade.
Although risk management is one of the most important elements of safe trading, many traders overlook it due to lack of knowledge. However, managing these concepts can be the key between gambling your money or investing wisely. A trader can generate substantial profits in a matter of weeks, but lose all his money in just one trade if he does not have a proper strategy that allows him to collect profits and minimize his losses.
What is stop-loss and how is it calculated?
When talking about risk management, determining the stop-loss level for your trading operation becomes one of the first steps to do before opening a position in the market. The stop-loss, also known by the sign (S/L) is a type of order used to close a trade at a certain price point.
The main purpose of this action is to limit the losses of a trading operation, especially when the trader’s forecast is wrong. In this way, they only risk a small percentage of their capital, which is already pre-planned.
For example, if a trader sets his stop-loss at a price 3% below the price the cryptocurrency was at when he entered the market, then he would be limiting his losses to only 3% of the invested capital. To top it off, stop-loss orders are very popular among traders as they have no additional commissions, so they work as a kind of free “insurance policy”.
Stop-loss orders also allow traders’ decision making to be free of emotional influences. As mentioned above, the market is often driven by traders’ forecasts and expectations, which can be highly subjective. A trader may give a second chance to a cryptocurrency that is going to make him lose money because he has an emotional attachment to it or a subjective assumption about its behavior.
The stop-loss works with objective market data. When the cryptocurrency sells at a price that is too low (or high) and goes against the trader’s assumptions, then it can be said that the strategy is wrong and the trader was wrong to enter the market. When the stop-loss level is reached, the trader’s buy-sell contract is cancelled, preventing him from continuing to trade at prices that will only generate more losses and from which he may not recover. In other words, the possibility of giving a second chance to an investment that does not work is eliminated.
Invalidation level: is this where I place my stop-loss?
After learning about the benefits of stop-loss orders, many traders want to know how to calculate the exact point at which they should exit the market. A poorly placed stop-loss can not only generate losses, but can also take a trader out of the market when there was still a chance for the market to recover.
The first thing to know about the stop-loss is that its location will depend on the trader’s strategy. It is important to remember that every trader has his or her reasons for investing in a certain asset, which are usually based on an assumption or prediction that the market for that asset will behave in a certain way.
For example, a person may open a long position for bitcoin because he believes that the price of the cryptocurrency will enter an uptrend. Or, on the contrary, open a short position as he believes that the value will start to depreciate. Technical analysis (TA) and fundamental analysis (FA) allow traders to develop their own theories about how a certain asset will behave. However, a trader’s forecasts can be wrong, and to avoid irreparable losses, the stop-loss serves as an emergency button.
Taking into account that every trader operates based on a theory, and that losses will only be generated when this theory is refuted, then the stop-loss has to be located at that level where the market invalidates the trader’s strategy. That is, at what is known as the “level of invalidation”. This is the price or place on the chart where the trader’s market analysis is recognized as failed and he is beginning to perceive losses from the trade.
Let’s take an example. A trader has analyzed the bitcoin market and believes that it is undervalued. Because of this, he concludes that eventually the price of the cryptocurrency will recover and enter a bullish period. By that time the price is at $22,000, but this trader believes it will reach $30,000 per unit in a few weeks.
Likewise, the trader knows that the support level of the bitcoin price is around $20,000. Below this price the cryptocurrency is not usually traded, so he assumes that he will not perceive large losses if he enters the market with a price of 22,000 BTC. In this sense, the trader’s strategy is to enter the market with that price with a view to reaching $30,000 per BTC and only exiting the market if the cryptocurrency breaks the support level. That is, if BTC reaches a number like $29,700 per unit.
Stop-loss orders make it easier to plan for potential losses on a trade.
The latter price would be his stop-loss, since at that price it would be invalidating our trader’s theory. He believes that bitcoin will not trade below $20,000, but if the market ends up doing so, then his strategy will be wrong and he will lose money. To save his skin, it is better to get out at that level and not count on the possibility of prices improving in the distant future.
As we can see, a trader only makes a loss on a trade if his analysis was wrong. When a pattern you trust collapses, it is very likely that the whole strategy you have collapses as well. Therefore, it is important that the stop-loss of a trading strategy is calculated based on a previous technical analysis (TA) and not on stable percentages that some “trading gurus” usually propose as a magic formula.
The stop-loss level is not always in the same place, it varies depending on the operations. It is necessary to choose a place that allows daily price fluctuations not to cancel the operation. In this sense, some traders use tools such as the moving average or Fibonnacci indicators to calculate the right point where the strategy starts to have losses that are not sustainable.
What is risk per trade?
In addition to using stop-loss orders to keep potential losses in check, traders also often calculate how much money they are willing to risk on each trade in order not to lose more than they can recover. Thus, the concept of risk per trade is introduced.
The risk per trade is the percentage that a trader is willing to lose for each commercial operation he carries out. This percentage is not fixed, but depends on the strategy of each trader and the amount of capital available for investment.
In general, traders usually risk between 1% and 5% of their money on each trade. There is even a 1% rule followed by most traders where it is suggested never to invest more than 1% of the capital in a single trade. The objective is that, if the trader’s strategy is wrong and the operation results in negative numbers, the losses will not compromise all his available money.
For example, if a trader has a capital valued at 20,000 dollars and bets to lose only 1% of that money, then he would be risking 200 dollars in that operation. He will lose this money only if the cryptocurrency price exceeds the stop-loss level and the order is placed to take him out of the market.