In the fast-paced world of cryptocurrency trading, risk management is often the difference between making a profit and losing it all. While many traders rely on technical analysis for charting their market moves, there's a whole other dimension that could enhance trading strategies: risk optimization. Even if you've never dabbled in machine learning (ML) or artificial intelligence (AI), understanding some fundamental risk optimization methods can help you trade more effectively. Here's what you need to know.
Stop-Loss and Take-Profit
Two of the most straightforward yet effective risk management tools are stop-loss and take-profit orders. The stop-loss sets a predefined exit point for a losing trade, cutting losses before they spiral out of control. The stop loss is your saviour in case of a market crash, it’s the price at which you say “I’ve lost enough, I can’t afford to lose more” so you sell your asset to save yourself from further losses. A Common mistake that amateur traders make is to say “I’ve lost already a lot, I will hold my position, maybe the asset price will go up again”. This mindset, however, is a psychological defence mechanism to avoid the acknowledgement of the loss. The bitter fact for cryptocurrencies is that “It is never too low”, your investment can go down to “Zero” if you keep holding your position and Ignore your Stop-Loss.
Conversely, the take-profit order specifies a predetermined level where the trade will close out, locking in gains. In other words, you sell part of your profit to make sure you won’t lose it again. There are many advantages of take-profit, financially and psychologically. In a volatile market like the cryptocurrency market, taking the profit minimizes the emotional aspects of trading, enabling traders to stick to a predetermined strategy without second-guessing or panic selling. In addition, a take-profit strategy can help traders earn from rapid price movements.
Portfolio Diversification
Another essential strategy is portfolio diversification, the practice of spreading investments across multiple cryptocurrencies to reduce exposure to any single cryptocurrency performance. While cryptocurrencies can be volatile, different coins have different risk profiles and market behaviours. Combining them can reduce portfolio risk. Having a range of currencies can also provide better liquidity options. As many times, traders might need to sell some assets for personal reasons, portfolio diversification allows traders to sell some currencies which they made a profit from and keep holding the others. Moreover, trading different cryptocurrencies at the same time can also offer emotional benefits by reducing the psychological impact of losses in any single trade.
Buying and Selling thresholds This risk optimization method is specific to AI / ML-based trading strategies. Here we mention two advantages of setting thresholds. 1. Skipping small movements: Every trader knows that you can’t earn money on every small market movement, because most of the time, we are not fast enough, but also because there is a fee for each trade you make. Therefore, you always need to set a limit on how small is “too small” for you. For example, If you see that the predicted price of Ripple tomorrow is an upward movement of 0.5%, and assuming that the prediction has no error (Which is NEVER the case, there is always an error), why isn’t it a good idea to buy Ripple now? Firstly, you have a delay in buying, so Ripple price may have increased already by 0.2% by the time you made your decision. Secondly, a trade fee (around 0.1% based on the exchange platform) will be subtracted from you. Ok, now you still have 0.2% to win. If the price drops the day after, you will also have a small delay before selling your asset, in this case, you will lose the 0.2% that you have earned, or maybe more. 2. Escaping prediction errors: Because no price prediction is perfect, it’s essential to consider the prediction error range of the model before deciding to buy or sell the cryptocurrency. Let’s illustrate that with an example. You build a model with an average prediction error of 2% and you see that the price prediction for tomorrow is that it will go upwards by 1%, should you buy the asset? No, you shouldn’t! In this case, you should consider that the prediction error (2%) is higher than the predicted price movement (1%), which means that it’s possible that the price doesn’t move upwards at all or even move downwards. These are just two of the many advantages of setting thresholds. And everything about buying thresholds could also be said about selling thresholds.
In Summary
Risk optimization is an indispensable part of any meaningful trading strategy, and the good news is. By employing methods like stop-loss, take-profit, and other methods, traders can significantly improve their risk profiles. Of course, these are just a few risk methods we mentioned here, we will cover more in our later articles.
