Risk Management

Written by Edward Gonzales

March 10, 2021

Imagine that you have just found a great chart opportunity to trade a currency pair. All the technical factors are indicating a buy, and you determine you have found a quality trade. How much of your available capital should you invest in the trade opportunity? You could determine that by position sizing. 

You should learn how to safely manage the position size of your trades to make sure you always keep your risk low and protect your account from being “liquidated” or wiped out.

Let me tell you – I have been liquidated before (as many traders have) and trust me it is not a good feeling. It is difficult to see all your hard earned money lost due to poor position sizing skills. In fact, most traders would swallow this feeling and walk away from cryptocurrency, never to trade again. Never to realize their full potential or any of the possibilities that cryptocurrency has to offer. While it is possible to double your stake in a single trade with leverage, it is highly unlikely. No matter how spectacular your chart analysis is, you nor anybody else can know what the market is going to do next. You always want to be conservative in your trades so that you can live to trade another day. 

Position Sizing

Position sizing is the part of your trading system that tells you how many coins to buy or sell per trade. This is a vital part of your trading system that helps you keep your risk per trade as small as possible. With position sizing, you can continually trade to reap the positive edge that comes with a large sample of trades, even if you’re on a losing streak. Position sizing helps you determine:

  • How many coins should you long or short for any particular trade
  • What is your risk per trade and the overall risk of your portfolio
  • What returns can you expect for your portfolio

How to Determine Position Size

Step 1 — Check your net liquidation (available capital/funds)

Once you log into your exchange platform, you can view your net liquidation, which is the amount of capital/funds that you have for trading. For example, if you open a crypto exchange account and you fund it with $1,000, that is your net liquidation.

Step 2 — Determine your risk per trade

Risk refers to the maximum loss you are willing to take for every trade you place (stop loss percentage). This is the maximum you can lose if your stop-loss is hit. Remember this: it is not a good idea to risk more than 3% of your capital in any single trade. Depending on the trade setup situation, and once you gain some experience of course, you may opt to risk more loss for the potential of more gains. However, if you’re a new trader, my suggestion is to always start with a 1% risk per trade. This may prematurely cut you out of a lot of trades that could have gone the way you predicted, but it is the safer option to protect your funds as a novice trader. 

When you’re confident and experienced enough, you can raise it to 2% and eventually to 3% (or whatever YOU feel comfortable with). After you gain just a bit more experience through the markets and consume more knowledge, you will be able to catch on to different trends and see things differently. At that point, you may feel comfortable risking even more than 5% if you see the potential for a quality swing trade.

Once you decide on your risk per trade, you must stick with it consistently for a period of time before you raise it. You want to eliminate as many variables in your trading as possible as a beginner. You must also always be consistent with your risk per trade because you can never predict the outcome of any single trade. Remember: on a trade-by-trade basis, every trade outcome is random. 

Step 3 — Determine your position size for each trade

Just like they say, “Never put all your eggs in one basket,” you never want to put all your available funds into a single trade. If you trip and fall with that basket, then you have broken all your eggs. This would be similar to you putting all your funds into one trade. If that trade plays out in favor of your prediction, great, you have made a lot of profits. If that trade does not play out in your favor, tough luck, you may have just been liquidated. 

Ideally, I would not risk more than 10% of my available funds for any one single trade. This means if I had $100,000 available, I would not risk more than $10,000 on any one particular trade. I would diversify my funds to other cryptocurrency pairs in order to give myself a better chance of making more profits. 

As you gain experience and develop as a trader, you may grow confident placing more of your available funds into each trade. Of course, keep in mind that any investment you make could result in a total loss. This could happen with any investment whatsoever, not just cryptocurrency trading. I would advise you to always be conservative in your trades.

Important Notes About Position Sizing

No matter where you place your stop loss, you must always be consistent with your risk per trade. You must remember that regardless of where you place your stop loss, whether it’s 1% away or 10% away, your risk should always remain the same. You shouldn’t say things like, “This is going to be a winner, I’m going to risk 3%”, or “I’m not too confident with this trade, so I’ll risk 1%”. Once you decide on your risk per trade, such as 1%, you should risk 1% for every trade in order to achieve consistency. You can’t be consistently profitable if you keep changing your variables. The market has enough variables for you to overcome.

Always determine your stop loss before calculating the trade. Depending on the strategy and the specific candlestick pattern of the trade, you place your stop-loss at different distances (usually below the previous low of the candle). So, you must always determine your stop-loss first, and then calculate the trade to keep your risk consistent.

The percentage of risk per trade should be inversely proportional to your stop loss. The farther away your stop loss is from your buy order, the smaller your percentage of capital you should use for that trade. The closer the stop loss, the greater the percentage of capital you should use for that trade, with your risk staying constant.

Everyone knows that money management is a core component of trading success, but very few understand what this means on a deep level. Most experts barely scratch the surface, with the extent of their contribution being simply to advise people to risk a low percentage of your trading capital per trade. In reality, there is so much more. 

A well-designed money management model gives you the ability to meet your trading objectives, unlike any other aspect of your trading system. To do this, you will be required to rewire your mindset. You must think of every trade in terms of percentage loss or gain. Once you do this, you will never look at the market the same way again. 

If you can maintain a daily return ratio of 1.67% with a beginning trading balance of $10,000 USD, you could be making $6,000 a month in profits and around $72,000 a year in profits through compound investing. That percentage is hard to achieve in any market and unlikely for the average day trader, but very possible in the crypto markets. The average day trader is happy with anywhere between .45% – .85% per trade, and that is fine as well. Ultimately, you want to find a ratio that is realistically achievable to you based on your skill level. Some days you will have positive percentage gains from the market and other days you will have negative percentage losses from the market. 

Managing Leverage

When you apply leverage, you are using borrowed assets to trade with. This is not ideal for a trader who is just starting out. While using leverage properly could lead to great rewards, using leverage improperly could result in liquidation of your funds. Two general rules for using leverage: 

  • Never use more than x20 leverage
  • When using leverage, limit your stop loss to 1%

When you are using x20 leverage, a -1% stop loss will actually give you a -20% ROE (return on investment). Let that sink in. What that means of course, is a 1% gain would mean a 20% ROE. Some traders may want to use leverage in some scenarios. I recommend you do not use leverage as a beginner trader. If you do decide to use leverage, please never use more than x20 for your own sake. 

Diversification

One of the most important aspects of managing any portfolio is diversification. Diversification in cryptocurrency is obtaining different amounts of various coins to uphold your net worth. 

Once you start to consistently secure profits, your capital will grow larger. You have worked extremely hard to secure these profits with each trade you have placed. Not a single dollar comes easy, not through trading nor through a day job/trade. Why would you want to throw away your hard earned profits by risking them all in your next trade? You should be setting your profits aside into a separate “bag” (ledger wallet) by collecting various coins – coins that you believe will grow in value over the long run. This way, in 5-10 years you will have a nice collection of cryptocurrencies that will have increased in value, instead of just rent money and a trade history. 

A good way to start diversifying your portfolio is through the 10% rule. Practicing this rule, you would take 10% of the profits from each trade, purchase a digital asset, and hold it for many years. You would not sell this asset for any reason for the next (amount of years determined by you). You would neither “panic sell” the dips nor “pinch sell” the rallies for profits. You would actually want to accumulate more of the asset over the next few years if it were downtrending. 5-10 years from now, the price of a cryptocurrency you are trading will not be anywhere close to where it is now. It is important to diversify your profits and invest for the long run so you can live and retire comfortably through cryptocurrency trading. 

 Conclusion 

The objective with this article was to show you how position sizing is one of the most important parts of trading. However, having a good position sizing system is not good enough. You must also have one or more trading strategies with a positive risk/reward ratio, so that you are able to be a consistently profitable trader even if you only win 50% of your trades. As a trader, we cannot avoid losing trades because we do not have crystal balls. We can control how much we lose in our losing trades, and how much we win in our winning trades. To find out more about trading cryptocurrency visit our website to view our trading courses and free resources. 

By viewing any material or using the information within this publication you understand that this is general education material and you can not hold any person or entity responsible for loss or damages resulting from the content or general advice provided here. Trading cryptocurrency has potential rewards, but also potential risks. You must be aware of the risks and be willing to accept them in order to invest in the markets. Only trade with funds you can afford to lose. This publication is neither a solicitation nor an offer to buy/sell cryptocurrency or other financial assets. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed in any material on this website. The past performance of any trading system or methodology is not necessarily indicative of future results.

Written by Edward Gonzales © Crypto University 2021

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