Introduction
Whether you are an investor, trader, marketMarket A place where assets are bought and sold. makerMaker An entity that provides liquidity to a market by placing limit orders., or simply a novice, understanding and grasping the concept of risk management is crucial. To highlight its importance, it’s even possible to extend this concept to more everyday aspects: when you take out insurance, you are transferring the risk to others. You aim to become neutral regarding the risk of accidents, theft, etc., and the counterparty charges you a premium in exchange, alleviating you of this mental and financial burden.
In trading and crypto, it’s exactly the same principle. Unfortunately, there is no magic formula or anti-stop loss insurance that can guarantee your profitability, but it is entirely possible to optimize your risk according to your own appetite for it. It is an ongoing process that requires personalizing your trading style, but it is the best way to beat the market.
In this article, we will first cover the basics of understanding your investor profile, and then how to manage your own risk based on this initial definition.
Without further ado, let’s begin:
Understanding Your Investor Profile:
Clearly define your financial goals in the short, medium, and long term. Are you looking to fund your retirement, buy a house, pay for your children’s education, or simply grow your capital?
As an investor, risk-taking and understanding it can be broken down into three parts:
Short-term goals, such as building an emergency fund or saving for a vacation, have a horizon of one year or less and generally require liquid, low-risk investments. Medium-term goals, like buying a house or funding your children’s education, extend from 1 to 5 years and may involve slightly riskier investments for potentially higher returns. Long-term goals, such as retirement or creating significant wealth, span more than 5 years, allowing for investments in riskier assets due to the time available to absorb market fluctuations.
When defining your goals, it is important to precisely quantify the amount needed. This step will allow you to calculate how much you need to save or invest regularly to reach these goals. Also, keep in mind that your financial goals may evolve over time based on your personal situation, so flexibility is important. For this point, it is also crucial to understand that managing risk is a process that takes time and requires constant improvement.
In determining your goals, consider the level of risk you are willing to accept to achieve them. Short-term goals generally require a more conservative approach, while long-term goals might allow for taking more risks to aim for higher returns.
Once you have clearly and precisely defined your goals, you can develop an investment strategy tailored to these targets and your risk tolerance profile. Remember to regularly review your goals to ensure you are progressing toward their achievement.
Adapting Your Profile to Desired Risk
We will define three typical profiles for three types of personalities commonly found in the crypto ecosystem, gradually ranging from the least risky to the most risky. Each profile will have a benchmark they aim to outperform and a maximum drawdown to adhere to. This list is not exhaustive and serves as a guide to better define your own profile, as there are as many investors as there are possible profiles.
Conservative Investor
This profile prioritizes capital preservation and risk minimization. It invests mainly in well-established and high-capitalization cryptocurrencies, such as Bitcoin and Ethereum.
They wish to diversify their investments and ensure that their annual drawdown does not exceed 5 to 10%. The return goal may exceed 20%, but during a bear marketBear Market A prolonged period of declining asset prices., this type of profile might tend to allocate to stablecoins to preserve capital while waiting for bullishBullish A positive outlook on the market or a project, believing that prices are likely to rise. signals.
Their benchmark, the performance index they seek to outperform, will be more traditional markets, which do not offer the same risk as cryptocurrencies, which average an annual return between 7% to 10%. This profile has advantages such as simplicity in position-taking, reasonable returns based on allocated capital, and low risk, thus resulting in lower mental stress.
Moderate Investor
This profile is willing to take a bit more risk for higher returns. They invest in a broader rangeRange The difference between the highest and lowest prices of an asset within a specific period. of cryptocurrencies, including some mid-cap and promising projects. Their annual drawdown can range from 10 to 50%, depending on their conviction and action plan. They closely monitor their portfolio and may adjust their investments based on market trends. During a bull run, this profile generally has their entire portfolio exposed to capitalize on the current trend.
Their benchmark might be blue-chip cryptocurrencies like Ethereum or Bitcoin. This profile benefits from simplicity in position-taking similar to the first profile and controlled portfolio risk. It is also very flexible in decision-making. However, it is common for them to need to monitor the market and manage their positions at least weekly to stay informed of market variations and adjust their plan. Thus, the mental load is greater than for Profile #1.
Aggressive Investor
This profile is the riskiest and is ready to invest in more volatile and speculative cryptocurrencies. They might be attracted to ICOs, low-cap DeFiDeFi DeFi services use smart contracts, decentralized protocols, and tokens to offer a range of financial services that can sometimes replace those offered by banks, such as lending/borrowing, asset management, insurance, or asset exchange. tokens, and emerging projects with high growth potential. They accept significant fluctuations in their portfolio’s value and are prepared to lose a substantial portion of their capital. They might adopt active trading strategies, including day tradingDay Trading The buying and selling of assets over short intervals within the same day to make profits., scalpingScalping A trading strategy aimed at making small, quick profits by exploiting minor price movements., or others, to profit from rapid market movements. Their annual drawdown can vary between 50% and 100% of the invested capital.
This profile is the most challenging to manage as it requires a balance between coherent risk management and significant risk-taking. Additionally, it demands active management of positions and can adopt any trading style. It is common for investors without a defined plan to end up in this category out of desperation. They also do not have a benchmark, aiming simply to extract as much profit as possible from the market while preserving their capital for as long as possible.
It is essential to note that risk and return are generally closely related. The riskier the investor’s profile, the higher the potential return, but also the likelihood of significant losses. They tend to gravitate toward anything that seems like a good trade.
Managing Position Size
To determine the optimal position size, it is essential to consider your risk tolerance and investor profile. For this, I encourage you to review the previous section to guide you in this search.
First, you will need to assess the risks associated with the assetAsset Any digital asset, including cryptocurrencies. you are investing in. More volatile or speculative assets generally require smaller positions. Also, consider the liquidityLiquidity The ease with which an asset can be bought or sold without affecting its price. of the asset, as illiquid assets can be difficult to sell when needed. Liquidity simply represents the ease of converting one crypto into another more stable one, for example.
Using stop-loss orders is a common strategy to determine position size. You can set an acceptable loss threshold and allocate your capital accordingly. For example, if you decide not to lose more than 5% of your total capital on a single position, you can use a stop-loss order to determine the position size based on this limit.
It is worth noting that it is neither necessary nor recommended to use only “hard” stop-losses or Hard SL. Doing so reduces your flexibility and adds an element of chance to your investment decisions. It is advisable to use a layering of your stop-losses for better risk management, just as it is recommended to use layering for your entry orders.
You can also reassess position size based on market evolution and your investment strategy. For example, adjust the position size based on new information or past performance, though this does not guarantee future performance.
Position size management should also take into account your emotional resilience. Do not over-invest in an asset to the point of experiencing excessive stress from price fluctuations, as this might lead you to make irrational decisions that you would not normally make.
Ultimately, managing position size is a delicate balance between maximizing potential returns and minimizing risks. It is a skill that refines with experience and should be adapted to your personal situation, as seen in the example above. By following these basic principles, you can positively impact your investments and maintain control over them.
The Different Risks to Be Aware Of
First, there is market risk, which refers to the risk related to price fluctuations of cryptocurrencies. In other words, as an investor, you are exposed to potential losses when the value of your investments decreases due to unfavorable market conditions. This includes unexpected “Black Swan” events, gradual changes in macroeconomic conditions, etc.
Next, there is credit risk: this is associated with the possibility that the issuer of a loan or financial product may not be able to repay the principal or interest. This primarily concerns large borrowers and DeFi lendingLending The act of lending cryptocurrency for interest. platforms but can also affect centralized exchanges (CEXCEX A centralized exchange platform controlled by a single entity.) that go bankrupt, such as FTX, to name a few.
As mentioned earlier, there is also a real liquidity risk: this involves the difficulty of buying or selling an asset without affecting its price. Illiquid assets can lead to significant losses when selling. When engaging with a low-cap crypto, it is crucial to be mindful of this. This is also known as ‘slippageSlippage The difference between the expected price of a trade and the actual price at which it is executed, often occurring during periods of high volatility or low liquidity.’ or the gap between supply and demand.
Additionally, an often-overlooked risk is operational risk, which concerns disruptions or failures in operational processes, including human errors, technological failures, and unexpected events. For example, this could be a miscalculated position size, a misclick, an error in configuring your trading terminal, etc.
Finally, the most overlooked risk by crypto investors: currency risk. For those looking to withdraw their gains in fiat currency, currency risk is indeed present when exchange rate fluctuations affect the value of investments in foreign currencies. Over periods of a year, the average volatilityVolatility The degree of variation in an asset's price over time. depending on the currency pairs in the forex market ranges between 10% and 15% annually. When holding stablecoins, you are indirectly exposed to the dollar itself.
Conclusion
In conclusion, risk management is a crucial pillar for any investor, whether in cryptocurrencyCryptocurrency A digital currency based on cryptographic technology to verify and secure its transactions and control the supply. A blockchain is used to store transactions transparently and verifiably. or other assets. Understanding your investor profile, setting clear financial goals, and customizing your approach based on your risk tolerance are key steps in the pursuit of profitability and capital protection. There is no magical path to profitability; it involves constant improvement of your analysis and significant self-work.
In summary, risk management is an ongoing process that requires reflection, patience, and adaptability. By following fundamental risk management principles, you can strengthen your position as an investor and navigate the sometimes turbulent waters of the crypto markets more effectively.
