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Risk Management

We constantly manage risks throughout our lives, whether during simple tasks like driving a car or when making decisions about insurance or medical plans. In essence, risk management is the process of assessing and reacting to risks.

Most of us manage these risks unconsciously in our daily activities. However, when it comes to financial markets and business administration, assessing risk is a crucial and highly conscious practice.

In economics, risk management can be described as the framework that defines how a company or investor handles the financial risks inherent to all kinds of business activities.

For traders and investors, this framework may include managing multiple asset classes, such as cryptocurrencies, Forex, commodities, stocks, indices, and real estate.

There are many types of financial risks, which can be classified in various ways. This guide provides an overview of the risk management process and presents 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, assessing risks, defining responses, and monitoring. Depending on the context, however, these steps may change significantly.

Setting Objectives​

The first step is to define the main goals. This is often related to the risk tolerance of the company or individual—in other words, how much risk they are willing to take to achieve their goals.

Identifying Risks​

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

Risk Assessment​

After identifying 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 its level of importance. It establishes what action should be taken if an unfavorable event occurs.

Monitoring​

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

Managing Financial Risks​

Several factors can cause a strategy or a trade setup to fail. For example, a trader might lose money because the market moves against their futures contract position or because they become emotional and sell out of panic.

Emotional reactions often cause traders to ignore or abandon 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 is a drastic contributor to 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, however, there are numerous ways to manage risk. Ideally, strategies should be revised and adapted continuously.

Below are a few examples of financial risks, along with a short description of how they can be mitigated.

  • Market risk: Can be minimized by setting Stop-Loss orders on each trade so that positions are automatically closed before incurring larger losses.
  • Liquidity risk: Can be mitigated by trading on high-volume markets. Assets with a high market capitalization tend to be more liquid.
  • Credit risk: Can be reduced by trading through a trustworthy exchange that acts as a central counterparty, mitigating the need for direct trust between individual buyers and sellers.
  • Operational risk: Investors can mitigate operational risks by diversifying their portfolio to prevent overexposure to a single project or company. They may also research to find companies that are less prone to operational malfunctions.
  • Systemic risk: Can also be reduced through portfolio diversification. In this case, diversification should involve projects with distinct proposals or companies from different industries, preferably those that have a very low correlation with each other.

Leverage & Leveraged Tokens​

Before explaining how position sizing should be done, we need to address leverage and leveraged tokens. This section 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 common in Forex and crypto trading.

By borrowing money from a broker, investors and traders can control larger positions. As a result, leverage magnifies the returns from favorable movements in an asset's price.

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

Leveraged trading can be confusing, especially for beginners. Before experimenting with leverage, it’s crucial to understand what it is and how it works. This article will focus on leveraged trading in crypto markets, but much 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, allowing you to trade with more capital than you currently have in your wallet. Depending on the crypto exchange, 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 you have $100 in your exchange account but want to open a position worth $1,000 in Bitcoin (BTC). With 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 must deposit funds into your trading account. The initial capital you provide is your collateral. The required collateral, or margin, depends on the leverage you use and the total value of the position you want to open.

Say you want to invest $1,000 in Ethereum (ETH) with 10x leverage. The required margin would be 1/10 of $1,000, meaning you need to have $100 in your account as collateral. If you use 20x leverage, your required margin would be even lower (1/20 of $1,000 = $50). Keep in mind that higher leverage increases the risk of liquidation.

Apart from the initial margin, you must also maintain a margin threshold for your trades. If the market moves against your position and your margin falls below the maintenance threshold, you will need to add more funds to your account to avoid liquidation. This threshold is also known as the maintenance margin.

Leverage can be applied to both long and short positions. Opening a long position means you expect the price of an asset to go up. In contrast, opening a short position means 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 only on your collateral, not your holdings. So, even if you don’t own an asset, you can borrow it to sell (open a short position) if you think the market will go down.

Leveraged Long Position Example​

Imagine you want to open a long position of $10,000 worth of BTC with 10x leverage. This means 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 had traded your $1,000 capital without 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 be liquidated even if the market only drops 10%. The exact liquidation value depends 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 (e.g., an email prompting you to add funds) before liquidation occurs.

Leveraged Short Position Example​

Now, imagine 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 with 10x leverage, you can 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 for 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 is only $1,000. Again, to avoid liquidation, you must 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 can also lead to much larger losses.

Another reason traders use leverage is to enhance their capital's liquidity. 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 elsewhere (e.g., trading another asset, staking, providing liquidity to decentralized exchanges (DEXs), or investing in NFTs).

Leveraged Tokens​

Leveraged tokens are tradable assets (e.g., ERC-20 tokens) that give holders leveraged exposure to the price movements of an underlying asset.

By design, leveraged tokens are not subject to liquidation in the same way as a normal leveraged position. However, they have their own unique set of risks, primarily related to their rebalancing mechanism. This rebalancing, which typically occurs daily, can lead to a phenomenon known as "volatility decay." During volatile market conditions, this decay can significantly erode the token's value, potentially leading to a near-total loss of investment, which is functionally similar to liquidation. Use them with extreme caution and never assume leveraged tokens are safer than traditional leveraged positions.

The goal of a leveraged token is to provide a multiple (e.g., 3x or -3x) of the daily performance of the underlying asset. For example, for every 1% that Bitcoin goes up in a day, a 3X Long Bitcoin Token aims to go up by 3%. Conversely, for every 1% Bitcoin goes down, the token aims to go down by 3%.

Typically, these tokens rebalance daily at a specific time. Some may also rebalance intra-day if the underlying asset's price changes by a significant percentage (e.g., 10%). However, rebalancing rules can vary between different tokens and the exchanges that offer them.

Important Note: Ensure you fully understand how leveraged tokens work before trading them. Like all leveraged products, they are inherently risky.

How To Manage Risks With Leveraged Trading​

Trading with high leverage might require less capital to start, 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 provides a larger margin of error. This is why some 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, while take-profit orders do the opposite: they automatically close your position when profits reach a certain value, allowing you to secure gains before market conditions change.

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

Leverage In Summary​

Leverage allows you to get started with a lower initial investment and offers the potential for higher profits. However, leverage combined with market volatility can cause rapid liquidations.

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

Position Sizing​

Introduction​

No matter the size of your portfolio, you must exercise proper risk management. Otherwise, you risk depleting your account and suffering considerable losses. Weeks or even months of progress can be wiped out by a single poorly managed trade.

A fundamental goal of trading or investing is to avoid making emotional decisions. When financial risk is involved, emotions play a huge part. You must be able to keep them in check so they don’t negatively affect your trading and investment decisions. This is why it’s useful to create a set of rules to follow during your activities.

Let’s call these rules your trading system. The purpose of this system is to manage risk and, just as importantly, to help eliminate unnecessary decisions. This way, your trading system won’t allow you to make hasty and impulsive decisions when it matters most.

When establishing these systems, you need to consider a few things: What is your investment horizon? What is your risk tolerance? How much capital can you risk? In this article, we’ll focus on one specific aspect: how to size your positions for individual trades.

To do that, we first need to determine your trading account size 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 step, it’s an important consideration. Especially for beginners, it can be helpful to allocate specific portions of your portfolio to different strategies. This way, you can more accurately track the progress of each strategy and reduce the risk of over-leveraging your capital.

For example, if you believe in the future of Bitcoin and have a long-term position stored on a hardware wallet, it’s probably best not to count that as part of your active trading capital. In this way, determining account size is simply identifying the available capital 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 trading account you’re willing to risk on a single trade.

The 1% Rule:

In the financial world, a common strategy is the 1% rule (sometimes cited as the 2% rule). According to this rule, a trader should not risk more than 1% of their account on a single trade.

While this is a popular guideline, many traders, especially in the volatile crypto market, adopt an even more conservative approach. For example, some may risk only 0.5% or 0.25% of their account per trade.

This rule dictates that if your trade idea is wrong and your stop-loss is hit, you will only lose that predefined percentage of your account. This does not mean you only enter trades with 1% of your capital. It is the maximum loss you are willing to accept on one trade.

note

  • In risk management, the level of risk can vary based on the source of capital. For instance, proprietary trading firms often enforce strict risk limits, such as 0.25% per trade, while traders using personal capital might choose a slightly higher risk, such as 0.50%.

  • The position size should always be determined by your stop-loss. For accurate sizing, consider using a position size calculator.

How To Determine Trade Risk​

So far, we’ve determined our account size and account risk. Now, how do we determine the position size for a single trade? We must identify the point at which our trade idea is invalidated.

This is a crucial consideration for almost any strategy. When it comes to trading and investing, losses are an unavoidable part of the process. They are a certainty. Trading is a game of probabilities; not even the best traders are always right. In fact, some traders can be wrong more often than they are right and still be profitable. This is possible through proper risk management and a consistent trading strategy.

As such, every trade idea must have an invalidation point. This is where you say: “My initial idea was wrong, and I should exit this position to mitigate further losses.” On a practical level, this is where you place your stop-loss order.

How you determine this point depends entirely on your individual trading strategy and the specific setup. The invalidation point can be based on technical parameters, such as a support or resistance area, a break in market structure, or signals from indicators.

There isn’t a one-size-fits-all approach to determining your stop-loss. You must decide which strategy best suits your style and set the invalidation point accordingly.

How To Calculate Position Size​

Now we have all the ingredients to calculate position size. Let’s say you have a $5,000 account and have established that you will not risk more than 0.5% on a single trade. This means you cannot lose more than $25 on one trade.

The formula to calculate position size is as follows:

Position Size = Risk Amount / Stop-Loss Percentage

Where:

  • Risk Amount = Account Size × Account Risk Percentage (e.g., $5,000 × 0.5% = $25)
  • Stop-Loss Percentage = The distance from your entry price to your stop-loss price, as a percentage (e.g., 5% or 0.05).

For example, if your entry price is $100 and your stop-loss is at $95, your stop-loss percentage is 5%. Using the formula: Position Size = $25 / 5% = $25 / 0.05 = $500

So, you would open a position worth $500. If the price drops 5% to your stop-loss, you would lose $25 ($500 * 5%), which is exactly your predetermined risk amount.

Notes Concerning Position Sizing​

  1. Calculating position size isn’t based on an arbitrary strategy. It involves determining your account risk and identifying your invalidation point before entering a trade.
  2. An equally important aspect of this strategy is execution. Once you have determined the position size and invalidation point, you should not alter them after the trade is live.
  3. If you are using leverage, your position size refers to the total notional value of the position (your margin multiplied by the leverage). The position sizing formula remains the same, but the capital you must provide as margin will be smaller.

Hedging​

Hedging is a risk management strategy used to reduce exposure to potential losses. It involves taking an offsetting position in an asset to minimize risk in an existing position. In other words, hedging is like taking out insurance on a trade.

There are various ways to hedge in trading. The most common strategies include:

Using options contracts: Options contracts give traders the right, but not the obligation, to buy or sell an asset at a predetermined price (the strike price) on or before a specific date. A trader can use options to hedge against potential losses. If they are long on an asset, they can buy a put option. If they are short, they can buy a call option. If the price moves against their primary position, they can exercise their option to limit their losses.

Using futures contracts: Futures contracts are agreements to buy or sell an asset at a predetermined price at a specific time in the future. A trader can hedge by taking an opposite position in the futures market. For example, if a trader is long on an asset, they can sell futures contracts. If the asset's price falls, the profit from their futures contract can offset the loss in their original position.

Using correlated assets: Traders can also hedge by taking a position in a correlated asset. For example, if a trader is long on a particular stock, they can hedge their position by shorting a correlated stock or an index. If the price of the original stock falls, the trader can make a profit on their short position, which will help offset the loss on the long position.

Partial Hedging or Locking: One strategy traders can use on the same Forex pair is known as "locking" or "partial hedging." This involves taking opposite positions in the same currency pair to offset potential losses. See the example below for clarification.

Suppose a trader is long on the EUR/USD pair, expecting the Euro to appreciate against the US dollar. However, they are concerned the exchange rate may reverse. To hedge, the trader can take an opposite position by opening a short position on EUR/USD, effectively "locking in" the current exchange rate.

If the exchange rate moves against the trader's original long position, the loss on that trade will be offset by the profit from their new short position, and vice versa. As a result, the trader's net position remains relatively stable, protecting them from further losses. The key is to ensure the two positions are roughly equal in size so that profits and losses cancel each other out.

Hedging can be an effective risk management strategy, especially when combined with other techniques like position sizing and stop-loss orders. By hedging, traders can limit losses and protect capital during unexpected market movements. However, hedging has its own costs, such as options premiums or futures maintenance fees, which can reduce profits. Therefore, traders should carefully weigh the potential benefits and costs before using this strategy.

Risk-to-Reward Ratio​

The risk-to-reward ratio tells you how much risk you are taking for a given potential reward.

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

Whether you’re day trading or swing trading, there are fundamental concepts about risk that you should understand. These form the basis of your understanding of the market and provide a foundation to guide your trading activities. 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, a crucially important aspect of active trading is understanding how much risk you are taking in relation to the potential reward. In other words, what is your risk-to-reward ratio?

What Is The Risk-to-Reward Ratio?​

The risk-to-reward ratio (R/R ratio or R) calculates how much risk a trader is taking for a potential reward. In other words, it shows the potential profit for each dollar you risk on an investment.

The calculation is very simple. You divide your maximum risk by your net target profit. To do this, you first identify where you want to enter a trade. Then, you decide where you would take profits (if the trade is successful) and where you would place your stop-loss (if it’s a losing trade). This is crucial for proper risk management. Good traders set their profit targets and stop-loss before entering a trade.

With both your entry and exit targets defined, you can calculate your risk-to-reward ratio 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-to-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% above your entry price. At the same time, you ask: where is my trade idea invalidated? That’s where you should set your stop-loss order. In this case, you decide your invalidation point is 5% below your entry price.

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

So, our profit target is 15% and our potential loss is 5%. What is our risk-to-reward ratio?

It is 5% / 15% = 1/3. This is commonly expressed as a 1:3 ratio. This means that for each unit of risk, we are potentially winning three units of reward. In other words, for each dollar of risk we take, we stand to gain three. 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 stated, entry and exit points should be based on analysis, not on arbitrary numbers to fit a desired ratio. If a trade setup has a poor risk-to-reward ratio, it might be better to move on and look for a different setup.

Note that positions of different sizes can have the same risk-to-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 distance of our target and stop-loss from our entry.

Many traders do this calculation in reverse, calculating the reward-to-risk ratio instead. This is simply a matter of preference. In the example above, the reward-to-risk ratio would be 15% / 5% = 3:1. A higher reward-to-risk ratio is generally considered more favorable.

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 hand. What’s the potential risk? Since you’re doing something you shouldn’t, you might get caught by security. 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 the tiger raw meat with your bare hands. What’s the potential risk here? You can still get caught, but there’s also a chance the tiger could attack you and cause fatal damage. On the other hand, the upside is only slightly better than the parrot bet.

Which seems like a better deal? Technically, both are bad deals. Nevertheless, you’re taking on much more risk with the tiger bet for only a little more potential reward.

Similarly, many traders 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).

Also important to mention here is your win rate, which is the number of your winning trades divided by the total number of trades. For example, if you have a 60% win rate, you are profitable on 60% of your trades (on average).

However, some traders can be highly profitable with a very low win rate. This is because the risk-to-reward ratio on their individual trade setups accommodates it. If they only take setups with a reward-to-risk ratio of 10:1, they could lose nine trades in a row and still break even on the tenth trade. In this case, they would only have to win two trades out of eleven to be profitable. This is how powerful the risk vs. reward calculation can be.

Summary Tables & Cheat Sheets​

Consecutive Losses Probability Table​

This table shows the statistical probability of experiencing a number of consecutive losses (CL) based on your historical win rate (W%).

W%2 CL3 CL4 CL5 CL6 CL7 CL8 CL
40%100%100%100%100%99%93%79%
45%100%100%100%99%93%76%54%
50%100%100%100%95%78%52%31%
55%100%100%98%83%55%30%14%
60%100%100%92%63%32%14%6%
65%100%99%77%40%16%6%2%
70%100%93%55%21%7%2%1%
75%100%79%32%9%2%1%0%
80%98%54%14%3%1%0%0%

Breakeven Win Rate Table​

This table shows the win rate required to break even for a given reward-to-risk ratio.

R:R Ratio1:11.2:11.5:12:13:13.2:14:14.2:15:1
Breakeven Rate50.00%~45.45%40.00%~33.33%25.00%~23.81%20.00%~19.23%~16.66%

Breakeven Equation: Breakeven Win Rate = (1 / (1 + Reward:Risk Ratio)) x 100

Expert Notes​

  • You need to find a balance between your win rate and your reward-to-risk ratio that suits your psychology. A low win rate with a high R:R can be psychologically challenging, even if it is profitable over the long term.

  • Logically, setups with a higher R:R ratio tend to have a lower probability of success, and thus a lower win rate. Conversely, a high win rate with an unfavorable R:R (where risk is greater than reward) is often not a sustainable model. Many traders aim for a reward-to-risk ratio of at least 1.5:1.

  • Remember to factor in your exchange's fees, potential slippage, spreads, and funding rates when calculating risk, backtesting strategies, and analyzing your trading performance. These costs can significantly impact profitability.