Risk Management

Table of Content

Risk Management

We are constantly managing risks throughout our lives – either during simple tasks (such as driving a car) or when making new insurance or medical plans. In essence, risk management is all about assessing and reacting to risks.

Most of us manage them unconsciously during everyday activities. But, when it comes to financial markets and business administration, assessing risks is a crucial and very conscious practice.

In economics, we may describe risk management as the framework that defines how a company or investor handles financial risks, which are inherent to all kinds of businesses.

For traders and investors, the framework may include the management of multiple asset classes, such as cryptocurrencies, Forex, commodities, shares, indices, and real estate.

There are many types of financial risks, which can be classified in various ways. This guide gives an overview of the risk management process. It also presents some strategies that can help traders and investors mitigate financial risks.


How Does Risk Management Work?

Typically, the risk management process involves five steps: setting objectives, identifying risks, risk assessment, defining responses, and monitoring. Depending on the context, however, these steps may change significantly.

Setting Objectives

The first step is to define what are the main goals. It is often related to the risk tolerance of the company or individual. In other words, how much risk they are willing to take to move toward their goals.

Identifying Risks

The second step involves detecting and defining what the potential risks are. It aims to reveal all sorts of events that may cause negative effects. In the business environment, this step may also provide insightful information that isn’t directly related to financial risks.

Risk Assessment

After identifying the risks, the next step is to evaluate their expected frequency and severity. The risks are then ranked in order of importance, which facilitates the creation or adoption of an appropriate response.

Defining Responses

The fourth step consists of defining responses for each type of risk, according to their level of importance. It establishes what is the action to be taken in case an unfavorable event occurs.

Monitoring

The final step of a risk management strategy is to monitor its efficiency in response to events. This often requires a continuous collection and analysis of data.

Managing Financial Risks

There are several reasons why a strategy or a trade setup may be unsuccessful. For example, a trader can lose money because the market moves against their futures contract position or because they get emotional and end up selling out of panic.

Emotional reactions often cause traders to ignore or give up their initial strategy. This is particularly noticeable during bear markets and periods of capitulation.

In financial markets, most people agree that having a proper risk management strategy contributes drastically to their success. In practice, this could be as simple as setting Stop-Loss or Take-Profit orders.

A robust trading strategy should provide a clear set of possible actions, meaning that traders can be more prepared to deal with all sorts of situations. As mentioned, though, there are numerous ways of managing risks. Ideally, the strategies should be revised and adapted continuously.

Below are a few examples of financial risks, along with a short description of how people can mitigate them.

  • Market risk: Can be minimized by setting Stop-Loss orders on each trade so that positions are automatically closed before incurring bigger losses.
  • Liquidity risk: Can be mitigated by trading on high-volume markets. Usually, assets with a high market capitalization value tend to be more liquid.
  • Credit risk: Can be reduced by trading through a trustworthy exchange so that borrowers and lenders (or buyers and sellers) don’t need to trust each other.
  • Operational risk: Investors can mitigate operational risks by diversifying their portfolio, preventing exposure to a single project or company. They may also do some research to find companies that are less likely to experience operational malfunctions.
  • Systemic risk: Can also be reduced by portfolio diversification. But in this case, the diversification should involve projects with distinct proposals or companies from different industries. Preferably the ones that present a very low correlation.

Leverage & Leverage Tokens

Before explaining how position sizing should be done, we need to address the topic of leverage and leverage tokens. In this section, we will define them and explain their associated risks.

Leverage

Leverage is the use of borrowed money (called capital) to invest in a currency, stock, or security. The concept of leverage is very common in forex and crypto trading.

By borrowing money from a broker, investors can trade larger positions in a currency. As a result, leverage magnifies the returns from favorable movements in a currency’s exchange rate.

However, leverage is a double-edged sword, meaning it can also magnify losses. It’s important that forex and crypto traders learn how to manage leverage and employ risk management strategies to mitigate forex losses.

Leverage trading can be confusing, especially for beginners. But before experimenting with leverage, it’s crucial to understand what it is and how it works. This article will focus on leverage trading in crypto markets, but a great portion of the information is also valid for traditional markets.

Leverage In Crypto Trading

Leverage refers to using borrowed capital to trade cryptocurrencies or other financial assets. It amplifies your buying or selling power so you can trade with more capital than what you currently have in your wallet. Depending on the crypto exchange you trade on, you could borrow up to 100 times your account balance.

The amount of leverage is described as a ratio, such as 1:5 (5x), 1:10 (10x), or 1:20 (20x). It shows how many times your initial capital is multiplied.

For example, imagine that you have $100 in your exchange account but want to open a position worth $1,000 in bitcoin (BTC). With a 10x leverage, your $100 will have the same buying power as $1,000.

You can use leverage to trade different crypto derivatives. The common types of leveraged trading include margin trading, leveraged tokens, and futures contracts.

How Does Leveraged Trading Work?

Before you can borrow funds and start trading with leverage, you need to deposit funds into your trading account. The initial capital you provide is what we call the collateral. The collateral required depends on the leverage you use and the total value of the position you want to open (known as margin).

Say you want to invest $1,000 in Ethereum (ETH) with a 10x leverage. The margin required would be 1/10 of $1,000, meaning that you need to have $100 in your account as collateral for the borrowed funds. If you use a 20x leverage, your required margin would be even lower (1/20 of $1,000 = $50). But keep in mind that the higher the leverage, the higher the risks of getting liquidated.

Apart from the initial margin deposit, you’ll also need to maintain a margin threshold for your trades. When the market moves against your position, and the margin gets lower than the maintenance threshold, you will need to put more funds into your account to avoid being liquidated. The threshold is also known as the maintenance margin.

Leverage can be applied to both long and short positions. Opening a long position means that you expect the price of an asset to go up. In contrast, opening a short position means that you believe the price of the asset will fall. While this may sound like regular spot trading, using leverage allows you to buy or sell assets based on your collateral only and not on your holdings. So, even if you don’t have an asset, you can still borrow it and sell (open a short position) if you think the market will go lower.

Leveraged Long Position Example

Imagine you want to open a long position of $10,000 worth of BTC with 10x leverage. This means that you will use $1,000 as collateral. If the price of BTC goes up 20%, you will earn a net profit of $2,000 (minus fees), which is much higher than the $200 you would have made if you traded your $1,000 capital without using leverage.

However, if the BTC price drops 20%, your position would be down $2,000. Since your initial capital (collateral) is only $1,000, a 20% drop would cause a liquidation (your balance goes to zero). In fact, you could get liquidated even if the market only drops 10%. The exact liquidation value will depend on the exchange you are using.

To avoid being liquidated, you need to add more funds to your wallet to increase your collateral. In most cases, the exchange will send you a margin call before the liquidation happens (e.g., an email telling you to add more funds).

Leveraged Short Position Example

Now, imagine that you want to open a $10,000 short position on BTC with 10x leverage. In this case, you will borrow BTC from someone else and sell it at the current market price. Your collateral is $1,000, but since you are trading on 10x leverage, you are able to sell $10,000 worth of BTC.

Assuming the current BTC price is $40,000, you borrowed 0.25 BTC and sold it. If the BTC price drops 20% (down to $32,000), you can buy back 0.25 BTC with just $8,000. This would give you a net profit of $2,000 (minus fees).

However, if BTC rises 20% to $48,000, you would need an extra $2,000 to buy back the 0.25 BTC. Your position will be liquidated as your account balance only has $1,000. Again, to avoid being liquidated, you need to add more funds to your wallet to increase your collateral before the liquidation price is reached.

Why Use Leverage?

As mentioned, traders use leverage to increase their position size and potential profits. But as illustrated by the examples above, leveraged trading could also lead to much higher losses.

Another reason for traders to use leverage is to enhance the liquidity of their capital. For instance, instead of holding a 2x leveraged position on a single exchange, they could use 4x leverage to maintain the same position size with lower collateral. This would allow them to use the other portion of their money in another place (e.g., trading another asset, staking, providing liquidity to decentralized exchanges (DEX), investing in NFTs, etc.).

Leverage Tokens

These are ERC-20 tokens that offer leverage to holders. By using these tokens, you automatically gain a leveraged position, unlike traditional trading methods.

Although the leverage tokens do not get liquidated by definition, they can lose all their value with their rebalancing mechanism depending on the market and the underlying asset which is almost like losing all the investment similar to being liquidated but in a different fashion. Use them with extreme caution. Never assume that leverage tokens are safer than traditional leverage. All leveraged products that exchanges offer carry a degree of risk that you need to be aware of before starting up.

Leveraged tokens feature both fixed and variable leverage. Conventionally, these assets rebalance themselves daily at a specific time depending on the exchange or when the spot market price changes by 10%. However, it’s not the same for all crypto exchanges. Some exchanges have different sets of rules in place for rebalancing.

Important Note: Make sure you properly understand leveraged tokens before you trade them. They are risky in nature like any leverage-related product or service.

How Is Leverage Calculated?

Let’s say you are holding a 3X Long Bitcoin Token and its price is $19,269.15. The leverage will be 3X =$19,269.153/$19,269.15+3($19,269.15–$19,269.15).

Now, in case the price of 3X Long Bitcoin Token increases to $20,000, the leverage will be $20,0003/$20,000+3($20,000–$20,000).

When the price of a 3X Long Bitcoin Token (or any leveraged token you are using) decreases, the leverage goes up. On the other hand, if the price increases, it goes down.

For every 1% Bitcoin goes up in a day, 3X Long Bitcoin Token goes up by 3%; for every 1% Bitcoin goes down, 3X Long Bitcoin token goes down 3%.

How To Manage Risks With Leveraged Trading?

Trading with high leverage might require less capital to start with, but it increases the chances of liquidation. If your leverage is too high, even a 1% price movement could lead to huge losses. The higher the leverage, the smaller your volatility tolerance will be. Using lower leverage gives you more margin of error to trade. This is why Binance and other crypto exchanges have limited the maximum leverage available to new users.

Risk management strategies like stop-loss and take-profit orders help minimize losses in leveraged trading. You can use stop-loss orders to automatically close your position at a specific price, which is very helpful when the market moves against you. Stop-loss orders can protect you from significant losses. Take-profit orders are the opposite; they automatically close when your profits reach a certain value. This allows you to secure your earnings before the market condition turns.

At this point, it should be clear to you that leverage trading is a double-edged sword that can multiply both your gains and losses exponentially. It involves a high level of risks, especially in the volatile cryptocurrency market.

Leverage In Summary

Leverage allows you to get started easily with a lower initial investment and the potential to bring higher profits. Still, leverage combined with market volatility could cause liquidations to happen quickly, especially if you’re taking 100x leverage to trade.

Always trade with caution and evaluate the risks before taking on leveraged trading. You should never trade funds you cannot afford to lose, especially when using leverage. The same applies to leverage tokens.


Position Sizing

Introduction

No matter how big your portfolio is, you’ll need to exercise proper risk management. Otherwise, you may quickly blow up your account and suffer considerable losses. Weeks or even months of progress can be wiped out by a single poorly managed trade.

A fundamental goal when it comes to trading or investing is to avoid making emotional decisions. As financial risk is involved, emotions will play a huge part. You’ll need to be able to keep them in check so that they don’t affect your trading and investment decisions. This is why it’s useful to come up with sets of rules that you can follow during your investment and trading activities.

Let’s call these rules your trading system. The purpose of this system is to manage risk, but equally importantly, to help eliminate unnecessary decisions. This way, when the time comes, your trading system won’t allow you to make hasty and impulsive decisions.

When you’re establishing these systems, you’ll need to consider a few things. What’s your investment horizon? What’s your risk tolerance? How much capital can you risk? We could think of many others, but in this article, we’ll focus on one specific aspect – how to size your positions for individual trades.

To do that, first, we’ll need to determine how big your trading account is, and how much of it you’re willing to risk on a single trade.

How To Determine The Account Size

While this may seem like a simple, even redundant step, it’s a valid consideration. Especially when you’re a beginner, it may help to allocate certain parts of your portfolio to different strategies. This way, you can more accurately track the progress you’re making with different strategies, and also reduce the chance of risking too much.

For example, let’s say you believe in the future of Bitcoin and have a long-term position tucked away on a hardware wallet. It’s probably best not to count that as a part of your trading capital.
In this way, determining the account size is simply looking at the available capital that you can allocate to a particular trading strategy.

How To Determine The Account Risk

The second step is determining your account risk. This involves deciding what percentage of your available capital you’re willing to risk on a single trade.

The 2% Rule:

In the traditional financial world, there’s an investing strategy called the 2% rule. According to this rule, a trader shouldn’t risk more than 2% of their account on a single trade. We’ll go over what that means exactly, but first, let’s adjust it to be more suitable for the volatile cryptocurrency markets.

The 2% rule is a strategy suitable for investment styles that typically involve entering only a few, longer-term positions. Also, it’s typically tailored to less volatile instruments than cryptocurrencies. If you’re a more active trader, and especially if you’re starting out, it could be lifesaving to be even more conservative than this. In this case, let’s modify this to be the 1% rule instead.

This rule dictates that you shouldn’t risk more than 1% of your account in a single trade. Does this mean that you only enter trades with 1% of your available capital? Absolutely not! It only means that if your trade idea is wrong, and your stop-loss is hit, you’ll only lose 1% of your account.

How To Determine Trade Risk

So far, we’ve determined our account size and account risk. So, how do we determine the position sizing for a single trade? We look at where our trade idea is invalidated.

This is a crucial consideration and applies to almost any strategy. When it comes to trading and investing, losses will always be a part of the game. As a matter of fact, they’re a certainty. These are a game of probabilities – not even the best traders are always right. Actually, some traders might be wrong much more than they are right and still be profitable. How is that possible? It all comes down to proper risk management, having a trading strategy, and sticking to it.

As such, every trade idea must have an invalidation point. This is where we say: “our initial idea was wrong, and we should get out of this position to mitigate further losses”. On a more practical level, this just means where we place our stop-loss order.

The way to determine this point is entirely based on individual trading strategy and the specific setup. The invalidation point can be based on technical parameters, such as a support or resistance area. It could also be based on indicators, a break in market structure, or something else entirely.

There isn’t a one-size-fits-all approach to determining your stop-loss. You’ll have to decide for yourself what strategy suits your style the best and determine the invalidation point based on that.

How To Calculate The Position Size

So, now, we have all the ingredients we need to calculate position size. Let’s say we have a $5,000 account. We’ve established that we’re not risking more than 1% on a single trade. This means that we can’t lose more than $50 on a single trade.

Let’s say we’ve done our analysis of the market and have determined that our trade idea is invalidated 5% from our initial entry. In effect, when the market goes against us by 5%, we exit the trade and take the $50 loss. In other words, 5% of our position should be 1% of our account.

  • Account size – $5,000
  • Account risk – 1%
  • Invalidation point (distance to stop-loss) – 5%

The formula to calculate position size is as follows:

// The equation is as follows:
Position Size = (Account Size x Account Risk) / Invalidation Point
// In our example above, the calculations will go as follows:
Position Size = $5000 x 0.01 / 0.05
$5,000 x 0.01 / 0.05 = $1,000

The position size for this trade will be $1,000. By following this strategy and exiting at the invalidation point, you may mitigate a much larger potential loss. To properly exercise this model, you’ll also need to take into account the fees you’re going to pay. Also, you should think about potential slippage, especially if you’re trading a lower liquidity instrument.

To illustrate how this works, let’s increase our invalidation point to 10%, with everything else being the same.

Position Size = $5,000 x 0.01 / 0.1
$5,000 x 0.01 / 0.1 = $500

Our stop-loss is now twice the distance from our initial entry. So, if we want to risk the same $ amount of our account, the position size we can take is cut in half.

Notes Concerning Position Sizing

  1. Calculating position sizing isn’t based on some arbitrary strategy. It involves determining account risk and looking at where the trade idea is invalidated before entering a trade.

  2. An equally important aspect of this strategy is execution. Once you’ve determined the position size and the invalidation point, you shouldn’t overwrite them once the trade is live.

  3. If you are using leverage, your position sizing equation should factor that as part of your risk management.


Risk To Reward Ratio

The risk/reward ratio tells you how much risk you are taking for how much potential reward.

Good traders and investors choose their bets very carefully. They look for the highest potential upside with the lowest potential downside. If an investment can bring the same yield as another, but with less risk, it may be a better bet.

Whether you’re day trading or swing trading, there are a few fundamental concepts about risk that you should understand. These form the basis of your understanding of the market and give you a foundation to guide your trading activities and investment decisions. Otherwise, you won’t be able to protect and grow your trading account.

We’ve already discussed risk management, position sizing, and setting a stop-loss. However, if you’re actively trading, there’s something crucially important to understand. How much risk are you taking in relation to the potential reward? How does your potential upside compare to your potential downside? In other words, what is your risk/reward ratio?

In this section, we’ll discuss how to calculate the risk/reward ratio for your trades.

What Is The Risk/Reward Ratio?

The risk/reward ratio (R/R ratio or R) calculates how much risk a trader is taking for potentially how much reward. In other words, it shows what are the potential rewards for each $1 you risk on an investment.

The calculation itself is very simple. You divide your maximum risk by your net target profit. How do you do that? First, you look at where you would want to enter the trade. Then, you decide where you would take profits (if the trade is successful), and where you would put your stop-loss (if it’s a losing trade). This is crucial if you want to manage your risk properly. Good traders set their profit targets and stop-loss before entering a trade.

Now you’ve got both your entry and exit targets, which means you can calculate your risk/reward ratio. You do that by dividing your potential risk by your potential reward. The lower the ratio is, the more potential reward you’re getting per “unit” of risk.

How To Calculate The Risk/Reward Ratio

Let’s say you want to enter a long position on Bitcoin. You do your analysis and determine that your take profit order will be 15% from your entry price. At the same time, you also pose the following question. Where is your trade idea invalidated? That’s where you should set your stop-loss order. In this case, you decide that your invalidation point is 5% from your entry point.

It’s worth noting that these generally shouldn’t be based on arbitrary percentage numbers. You should determine the profit target and stop-loss based on your analysis of the markets. Technical analysis indicators can be very helpful.

So, our profit target is 15% and our potential loss is 5%. How much is our risk/reward ratio? It is 5/15 = 1:3 = 0.33. Simple enough. This means that for each unit of risk, we’re potentially winning three times the reward. In other words, for each dollar of risk we’re taking, we’re liable to gain three. So if we have a position worth $100, we risk losing $5 for a potential $15 profit.

We could move our stop loss closer to our entry to decrease the ratio. However, as we’ve said, entry and exit points shouldn’t be calculated based on arbitrary numbers. They should be calculated based on our analysis. If the trade setup has a high risk/reward ratio, it’s probably not worth it to try and “game” the numbers. It might be better to move on and look for a different setup with a good risk/reward ratio.

Note that positions with different sizing can have the same risk/reward ratio. For example, if we have a position worth $10,000, we risk losing $500 for a potential $1,500 profit (the ratio is still 1:3). The ratio changes only if we change the relative position of our target and stop-loss.

It’s worth noting that many traders do this calculation in reverse, calculating the reward/risk ratio instead. Why? Well, it’s just a matter of preference. Some find this easier to understand. The calculation is just the opposite of the risk/reward ratio formula. As such, our reward/risk ratio in the example above would be 15/5 = 3. As you’d expect, a high reward/risk ratio is better than a low reward/risk ratio.

Risk vs. Reward Explained

Let’s say we’re at the zoo and we make a bet. I’ll give you 1 BTC if you sneak into the birdhouse and feed a parrot from your hands. What’s the potential risk? Well, since you’re doing something you shouldn’t, you may get taken away by police. On the other hand, if you’re successful, you’ll get 1 BTC.

At the same time, I propose an alternative. I’ll give you 1.1 BTC if you sneak into the tiger cage and feed raw meat to the tiger with your bare hands. What’s the potential risk here? You can get taken away by police, sure. But, there’s a chance that the tiger attacks you and inflicts fatal damage. On the other hand, the upside is a little better than for the parrot bet, since you’re getting a bit more BTC if you’re successful.

Which seems like a better deal? Technically, they’re both bad deals, because you shouldn’t sneak around like that. Nevertheless, you’re taking much more risk with the tiger bet for only a little more potential reward.

In a similar way, many traders will look for trade setups where they stand to gain much more than they stand to lose. This is what’s called an asymmetric opportunity (the potential upside is greater than the potential downside).

What’s also important to mention here is your win rate. Your win rate is the number of your winning trades divided by the number of your losing trades. For example, if you have a 60% win rate, you are making profit on 60% of your trades (on average).

Even so, some traders can be highly profitable with a very low winning rate. Why? Because the risk/reward ratio on their individual trade setups accommodates for it. If they only take setups with a risk/reward ratio of 1:10, they could lose nine trades in a row and still break-even in one trade. In this case, they’d only have to win two trades out of ten to be profitable. This is how the risk vs. reward calculation can be powerful.

Recommended Risk To Reward Ratios

When designing your trading strategy and testing it hundereds of times, you have to make sure that it has a logical risk to reward ratio that maximizes your advantage or edge.

Our team usually recommends the following:

  • For scalping, a logical risk to reward ratio would range between: 1:1.2 – 1:2. The optimal would be 1:1.5 (or more if your strategy allows without compromising your win rate). In case your risk to reward ratio is 1:1.2, your win rate has to be above 65% to make it worth your time. Otherwise, you will need to seek better strategies.

  • For day trading, your risk to reward ratio has at least to be 1:1.5. A logical range would be between 1:1.5 to 1:5. The optimal ratio for day traders is 1:3 (or more if your strategy allows without compromising your win rate). Again, like in scalping, you also need to have a decent win rate of at least 60%.

  • For swing trading, your risk to reward ratio has at least to be 1:3. A logical range would be between 1:3 and 1:10. The optimal ratio for swing traders high depends on their strategy. There is no right or wrong answer but 1:5 seems to be a good ratio for many swing traders. If your risk to reward ratio is 1:3 or more, a 55% win rate would be sufficient to keep up a good flow of consistent profits.

Risk To Reward Ratio Summary Table

Trading TypeMinimum R:ROptimal R:R
Scalping1:1.21:1.5
Day Trading1:1.51:3
Swing Trading1:31:5

Breakeven Win Rate Summary Table

R:R Ratio1:1.21:1.51:21:31:5
Breakeven Rate~45.45%40.00%~33.33%25.00%~16.66%

Breakeven Equation: Breakeven Win Rate = (Risk Rate / (Risk Rate + Reward Rate)) x 100

Expert Notes

  1. You need to balance between your win rate and your risk-to-reward ratio. A bad win rate with a high R:R is not psychologically friendly even if it turns out to be more profitable. That’s why here at AlgoStorm, we only trade strategies with a win rate of at least 65%.

  2. Logically speaking, the higher your R:R ratio is, the lower your win rate will be. Note as well that a very high win rate with a negative R:R ratio is not a sustainable model. We recommend that your risk to reward ratio should not drop below 1:1.2 and your win rate should not go below 55% on average.

  3. Note that your have to consider your exchange’s fees and the funding rate when doing your calculations and trading report.

Note: If you like to access the strategies that we use at AlgoStorm, join us today at: https://www.patreon.com/algostorm