Prioritize Capital Protection Before Making Profits - A Risk Management Guide By KuCoin

2021/07/28 09:30:35

Chance often favors the prepared. We've all heard that at some point. And although crypto trading is not a game of chance, the logic is the same. The crypto market is famous (or rather infamous) for its unpredictable volatility. So, to benefit from this volatility in the long term, you must ensure that you stay in the game long enough. That is where capital protection comes in. We have discussed a few risk management practices that are being followed by professional crypto traders across the globe. Let’s discuss.

The 1% Rule

Risk management is a rules-based system. It stipulates that no more than one percent of your account may be used for a particular trade. This is done as part of prudent capital management and to keep losses to a minimum.

It goes without saying that every trading strategy, no matter how profitable, is foolproof. Every trader has a bad day. The possibility of potential profits often lures novice traders. As the saying goes, the more you invest, the more you earn. While maybe true, the downside is that the more you invest, the more you also stand to lose. But this shouldn't discourage you from trading; it should encourage you to learn proper capital allocation techniques.

Maintaining your trades at 1% ensures that even if the market goes against you, you won't take a loss that you cannot recover from.

Always Use a Stop Loss Order

Even after observing the 1% rule, you should always set the stop loss for every position you take. This is also designed to limit your downside.

For example, let's say you open a long position (with 1% as mentioned), but the market instead adopts a long-term bearish trend. That means you have a losing trade in your hands. If these losses continue, your account could be wiped out. However, setting a stop loss, your position automatically closes after the losses in your trading account reach a specific level.

Consider Take Profit and Trailing Stop Loss Orders

Again, in a volatile market, you never know when slippage might occur. This means that you should always protect your profits. Take profit works similar to the stop loss, only that in this case, your trade closes when your profit reaches a particular amount or when the price reaches a specified level.

Trailing stops are used to protect losses of accumulated profits. Trailing stop orders are often attached to some pips below the prevailing market price for a long position and above the market price for a short position. This means that when the price fluctuates, the trailing stop changes along with it. When the trend changes, your position will be close when the market price reaches the trailing stop level.

While some might argue that this limits your upside, it is especially invaluable in volatile markets. For example, if you have a short position and the market is in a steady bearish trend, it means that your trade is accruing profits. But any sudden change in market sentiment may cause the trend to change without notice. With a trailing stop, the profits accumulated won't be lost.

Typically, when setting your stop loss and taking profit levels, always consider the current market volatility and the support and resistance levels. Technical indicators like the average true range (ATR) are of great use here. This will also depend on the holding period of your trade. As a rule, the volatility is higher with a holding period of several days than within one day. This means for you: The longer the holding period, the more generous the stop loss, and TP must be set.

The Risk-On Risk-Off Approach

Risk-On Risk-Off, also known as RoRo, is often used in risk assessments.

The risk appetite in trading often depends on the individual risk type. Some investors are very willing to take risks, and others are risk-averse. Your trades should be adapted to the individual risk type. For this to succeed, however, potential sources of risk must first be identified.

RoRo describes the market behavior of individual investors in the market. How market participants react to events in a market allows conclusions drawn about investors' risk tolerance. It can be assumed that most investors do not know their risk type or play with the degree of risk. Knowing your risk appetite is critical in protecting your capital.

Risk-on and risk-off trading entirely depends on the market sentiment. It depends on the current news and changes in the market sentiment – since traders' and investors' strategies change frequently. Those who trade risk-on-risk-off should always be aware that the herd instinct of other investors often leads to high, short-term fluctuations in the markets.

Also, various trading strategies determine Risk-On Risk-Off trading. You should know the markets so well that you can spot the transitions from risk-on to risk-off. In addition to observing the market sentiment, technical analyses are also indispensable to detect changes in the market at an early stage.

It is also possible to trade risk-off. This works especially well if you have a diversified portfolio. The probability here is correspondingly high that the risk between risk-on and risk-off market exposures neutralizes, and you can thus sit out risk-on phases within a market sentiment. Risk-off is generally an investment opportunity that also works passively with a diversified portfolio. With fundamental analysis, it is also possible to estimate risk-on phases in a diversified portfolio and exit at the beginning of the upward trend.

Bottom Line

Every reliable crypto exchange has a disclaimer that trading often involves risks. And that is true. But with proper risk management techniques, you can significantly mitigate the risks involved and protect your capital to ensure that you are profitable in the long run. Follow the KuCoin blog for your daily dose of trading education. All the best!

At KuCoin, you get to access multiple order types to apply your robust Risk-Management practices discussed above.