What is risk-management?

In one of our previous articles we analyzed different trading styles and methods of market analysis. However, in practice even a very good understanding of the market and application of trader’s (manager’s) skills do not give a stable profit on the market. One shall not forget that trading is a work with probabilities and the trader’s task is to find such situation in which the probability of price movement in this or that side is higher than in the other one. Knowing this, it is safe to say that it is almost impossible to avoid losses in trading. It is important to learn to accept losses, work with them properly and manage them. Exactly for this purpose we need risk-management, which is a set of rules aimed at defining the choice and amount of possible losses as well as actions of a trader in case of their achievement. Risk management is present not only in trading, but also in investing, business and many other spheres of human activities.

The tasks of using risk management

1. To limit potential losses in case the market does not meet the trader’s expectations.
2. Rationally allocate a trading deposit to different positions.
3. Get a positive mathematical expectation from a deal and reinforce it with a system of losses limitation.
4. Do not allow the trader to lose a large part of the deposit during a series of losing trades.

Basic rules and principles of risk management

1. You should not enter into transactions with the entire deposit.
2. You should always have enough money to open a new deal, the prospect of which can appear at any time.
3. You must diversify your investments.
4. Adhere to a pre-selected risk management system.
5. It is necessary to know one’s risk management system.
6. It is important to restrain emotions. Fear and greed must not be allowed to take over. Opening deals only with a cool head.
7. Do not risk with money you cannot afford to lose.
8. You must always limit losses, including potential losses.
9. It is desirable to have an insurance fund from which unexpected losses can be covered in case of emergency.If it is possible to place a stop loss, then it must be done in any case.
10. Do not forget about hedging additional risks, if any.

Stop Loss and Take Profit

Stop-loss — the exchange order, exposed in the trading terminal by a trader or investor in order to limit their losses when the price reaches a predetermined level.

Take-profit — a stock exchange order placed in order to fix profit on position when the price reaches a certain level.

Both orders can be placed simultaneously or immediately after entering the position. In some cases experienced traders do not place take profit orders and fix profit manually, but stop loss must be set. Trading without placing stop-loss orders leads to huge losses and rapid nullification of the deposit, and in case we are talking about margin trading — to liquidation.

Also, it is necessary to strengthen the positive mathematical expectation with these orders. It is necessary to observe the take profit to stop loss ratio of not less than 2 to 1. The higher the ratio, the better. Maintaining this ratio allows the trader to cover several losing trades with one profitable one, i.e., he/she has the right to make a mistake. However, this ratio will be meaningless if the trader takes various risk per trade.

Risk per trade

One more important parameter that every trader should determine before opening a position is the amount of losses he or she can take in case the position is closed using a stop-loss. It is best to measure it not in a specific number (0.08 BTC, $50,000, $1,000, etc.), but as a percentage of the deposit. A trader who adheres to this rule will never lose all his money.

The size of risk per transaction is determined by every trader independently, however, there are some generally accepted values. It is considered that the normal level is 1–3% risk per transaction. Since the entire risk-management system is designed to protect the trader from a series of failed transactions, it is logical that the lower risk per transaction is taken, the better it is protected.

Hedging

An interesting subject is hedging — insuring the risk of price changes. There are various methods of hedging, but the main one is with derivatives (futures, options, etc.). It is used by many businesses which have nothing to do with stock speculation. Traders who hold their positions for the long term mainly hedge their positions.

Here is an example of hedging using some Octopus Crypto Fund pools, whose activities are aimed at trading NFT tokens. Many NFTs are traded in prices to Ethereum. To significantly reduce losses when Ethereum falls sharply, managers gradually build up positions in put options with a $1,000 strike on this coin. Thus, they insure funds of the pool against a sharp fall of Ethereum.

Conclusion

Risk management is an essential part of every trader’s work. Without risk management trading turns into some analogue of casino, a gamble, which will inevitably lead to loss of all funds.