“I got caught in the hype. Then the bubble burst,” says Peter McCormack. Many investors like Peter around the world made millions and then lost them to the parabolic volatility inherent to cryptocurrencies. This underpins the need for awareness regarding risk management among cryptocurrency investors and traders.
Imagine investing in Bitcoin with the hopes of doubling the investment, but instead the value halves. That can pinch hard, especially if that was money that the investor couldn’t afford to lose. It doesn’t have to be this way, though.
Just like with every other asset class, there are ways to manage risks when it comes to investing or trading cryptocurrencies. Investors can minimize, though not eliminate, the risks that accompany crypto investing. In some cases, this also means settling for lower returns, but that’s a tradeoff worth making.
Safe Ways to Invest and Trade Cryptocurrencies
There are various risks associated with cryptocurrency trading and investment. The most prominent risk is volatility, but it’s not the only one. Crypto traders and investors should also watch out for potential security threats and regulatory intervention.
Cryptocurrencies, at the moment, aren’t heavily regulated. Their price is determined solely by the demand and supply. As jurisdictions begin to accept cryptocurrencies in the future, this could change. Some countries may ban cryptocurrencies in the future, too. This is one risk that is hard to mitigate, and therefore, investors will need to accept it “as is” at least for now.
Other threats like volatility and security threats can be managed to a certain extent. Following are the ways to accomplish this.
Stablecoins like USDC
Stablecoins are cryptocurrencies that are pegged to the value of another asset class, generally fiat currencies. They tend to be far less volatile since their value depends on the value of the underlying currency, rather than the demand and supply of the coin itself.
Investors that are wary of volatility could gain crypto exposure through stablecoins. Some of the most liquid stablecoins are USDC and USDT, which is great for investors who like the option of being able to exit the position at any time. Stablecoins generate lesser returns but are also much less volatile.
Stablecoins will rarely generate a capital gain for investors. They do generate interest income, though. For instance, investors can buy USDC from MoonPay and deposit it on a platform like Crypto.com or YouHolder. They generally yield upwards of 8%; nothing to sneeze at, but certainly less than what high-risk cryptocurrencies could generate.
In essence, stablecoins are almost like fixed-income securities of the crypto-verse. Fortunately, they offer far better returns than traditional fixed-income securities like CDs and even surpass returns generated by other debt securities by a good margin.
The 1% risk rule
Stablecoins are a good option for risk-averse investors, but they don’t do much for traders. Traders, instead of looking away from volatility altogether, are better off managing it. The 1% risk rule has been around for a while and traders use it while trading equities and forex. The rule can also be applied to trading crypto as well.
The rule suggests that a trader should maintain a risk exposure of less than 1% of the trading account value on a single trade.
This shouldn’t be misconstrued as a $500 cap on trades for a trader with an account value of $50,000. Traders may use their entire account balance, and even use leverage on their trades. The rule suggests capping the risk at 1% of the account value on a single trade.
Traders can cap their risk with stop-loss orders. A stop-loss order is an order that automatically triggers a sell trade when the price breaches a certain threshold.
For instance, a trader wants to take a bet on ETH and it currently trades $1,769.99.
The previous short-term swing low is $1,751.82.
The trader may place a stop-loss order at $1,751.81, which caps the loss per 1 ETH to $18.18 ($1,769.99 – $1,751.81). This figure then allows the investor to compute the number of ETH they should buy by dividing the 1% risk amount with the maximum loss per ETH:
Number of ETH to buy=$500$18.18=27.5 ETH
Rounding it down, the trader could place an order to buy 27 ETH at the current price, which will cost $47,789.73. Fortunately, the trader’s account value is greater. Even if it weren’t, the trader could use 2:1 leverage for the trade.
A few minutes later, ETH trades at $1,795.2.
The trader sells ETH and books a profit of $680.67, not counting the fees. This is a profit of 1.43% on the trade and 1.36% of the account value.
Note that in any case, the trader’s loss is capped at 1% of the account value. For instance, if the price drops to $1,700, the trader’s stop-loss order will initiate automatically at $1,751.81. The trader will lose $490.86, which is close to 1% of the account value of $50,000.
However, the trader’s upside is practically uncapped. If the trader sells ETH when it trades at $1,869.99, they will make $2,700 on the trade. That’s a profit of 5.65% on the trade and 5.4% of the account value of $50,000.
This is how the 1% rule can offer traders a safe way to trade even the most volatile cryptocurrencies without the risk of losing a significant amount. The 1% rule is more suitable for novice traders. Experienced traders may choose a higher number, preferably lower than 2%, that they feel comfortable with.
“Don’t put all your eggs in one basket,” they say. Modern portfolio theory says the same thing but in a different way. It suggests that investors should invest in uncorrelated assets to minimize the portfolio’s overall standard deviation, i.e., risk.
Diversification is the most critical risk management technique that all investors should learn about. In simple words, investors can diversify their portfolio by allocating a portion of their wealth to various asset classes such as cryptocurrencies, equities, debt, commodities, and alternative investments such as real estate.
It’s not necessary to include all asset classes, though. A financial advisor may be able to offer more detailed advice. In general, the lower the correlation between the assets in a portfolio, the better.
Cryptocurrencies are parabolically volatile and allow investors to generate decent returns with a relatively smaller capital. Investing a large portion of capital in cryptocurrencies is not required for producing tangible returns and it is often a risky proposition. It can send a portfolio’s overall risk soaring. It’s best to use capital that investors can afford to lose and use stop-loss orders to cap the losses.
Investors can even diversify within the crypto-verse, though it may be more challenging to do for novice investors. Investing a healthy portion of a portfolio’s crypto allocation in large-cap, slow-moving cryptocurrencies such as BTC and ETH and investing the remaining portion in fundamentally strong, small-cap cryptocurrencies is a good way to go about it.
Tie the loose ends on security
Cryptocurrencies are digital assets, so online security becomes a critical consideration for investors. Hackers are plentiful and on-guard for gullible investors that can help them make a quick buck. Let’s look at what investors can do to keep their cryptocurrencies safe against cyber threats.
- Secure the wallet
Cryptocurrency wallets may be primarily of two types, hot and cold. From a security perspective, cold (or physical) wallets are recommended.
Cold wallets look similar to flash drives and are protected by a private key that allows the owner of the device to decrypt the wallet and access its contents.
While cold wallets are safe from hackers, there’s one big risk. If the investor loses the password key, the wallet’s contents are rendered irrecoverable.
- Choose an exchange carefully
Some exchanges offer FDIC insurance, similar to the banks, on initial deposits of $250,000. Nevertheless, it’s best to move holdings off the exchange because if the exchange is hacked, or is shut down because of any reason, the holder will lose their entire holdings and have no recourse.
This is why crypto experts recommend sticking to an established exchange. BTC, ETH, XRP, and other popular cryptos are available on most exchanges. The options may be more limited for newer and unpopular cryptocurrencies. In either case, some due diligence is critical to ensure the safety of an investor’s holdings.
- Use two-factor authentication (2FA)
Always use 2FA on cryptocurrency exchanges for an additional layer of security. 2FA requires the investor to enter a One-Time Password (OTP) each time they want to log in to the account. Ideally, Google Authenticator would be a go-to for 2FA, but the next best option is the phone’s 2FA.
Stay Safe and Prosper
Cryptocurrencies are turning heads all over the world. Most investors don’t take the plunge because of the fear of volatility. A justified reason, no doubt. However, volatility can be managed if the investors are open to educating themselves on how to do it.
Returns generated by cryptocurrencies have changed many lives across the globe, and will likely change many more. Investors that are keen on playing the crypto game could use the best safety practices discussed above to shield their capital from volatility and security threats that plague the crypto-verse.
Great things take time. Investors that can manage volatility as well as stomach the residual volatility and stay invested for the long term will likely come out the other side as winners.
Author Bio: Arjun Ruparelia
Email – [email protected]
An accountant turned writer, Arjun writes financial blog posts and research reports for clients across the globe, including Skale. Arjun has five years of financial writing experience across verticals. He is a CMA and CA (Intermediate) by qualification.