Education

Lesson 2: Risk Management

I decided to move this lesson in the beginning of the course as most beginner traders don’t treat it seriously enough. Risk management is a very important element of profitable trading.

Many people who just started trading prefer to study Technical Analysis first, find profitable strategies and begin real trading too soon. The reality is, even if you get deep knowledge of market analysis and a “perfect” trading strategy, your results can be negative and your deposits can be reduced to 0 when the market reverses.

You should remember a very simple but very important reality: risk management is one of the most important components in trading.

• it will help you pass through the unstable and unpredictable market periods
• it will allow you to protect your deposit even against beginner mistakes
• it will limit your losses to a bearable level when your trading strategy proves to be wrong in unsuitable market conditions

Based on my opinion, proper risk management is the key to profitable trading.

Why? Let’s start from the beginning:

What is Risk Management?

As a definition, Risk Management (RM) is the process of analysis and identification of risk, as well as the acceptance and reduction of the uncertainty involved in an investment decision. In real life, RM happens whenever a trader simulates the potential for loss in a trade and takes the appropriate action in order to follow his objective and be comfortable with the risk he is taking.

In simple language:

Before starting a trade, we should think about what can be the outcome of a negative move vs. a positive move, and how much are we willing to accept to lose from that particular trade.

In addition to this definition, note one more important fact: nobody knows for sure where the market will go at a given time. This tells us that there are no 100% reliable signals and, as a result, trading becomes a risky action in the financial markets (or in crypto markets in our specific case).

To elaborate more, each time you open a new trade on the crypto market, you place your money in the risk zone and your wrong decisions can damage your deposit.

Based on these facts, you must trade thinking that each new trade can give you a loss or it can give you profit. You must be prepared for both outcomes. That is why you have to plan your trades before entering the market and for each trade you must think for yourself about the level of risk which you are ready to take.

How do you know if you are risking too much on a trade?

If you open a trade and the market price moves against your profit target, and you feel yourself uncomfortable with the loss, it means you took too much risk for this trade. This feeling is generated by because you surpassed your risk comfort level: you invested in the market too much from your deposit and next time you should trade with less volume to avoid this.

As a rule of thumb, the volumes you use for each trade should be portioned in such a way that they will allow you to close 5, 10, even 15 trades at a loss, and still have a working deposit available after suffering these losses. Your risk size for a signaled trade should be comfortable to you.

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When we talk about risk management, we also have to pay attention components such as stop-loss orders and diversification.

What is diversification of risk

Diversification is a risk management technique that advices to spread your trades or investments in a portfolio of assets, or crypto coins, in our case. The idea behind diversification is that, on average, your portfolio returns will be higher and pose a lower risk than if you just invested in one single coin.

Tell me again why diversification is good for my trades

A popular idiom for diversification would be “don’t put all your eggs in one basket”.

The point of diversification is that the profit made by some of your assets or trades will neutralize or be larger than the losses of the assets or trades that don’t perform so well.

Science backs this up too: in the stock market, studies and mathematical models have shown that a varied portfolio of 25-30 types of stocks is the most cost-effective method of risk reduction.

As a very simplified example, in normal market conditions, if you have trades in several coins, and Coin32 which is 10% of your deposit, takes a dive losing 6% in value, and, at the same time Coin53 out of which you traded also 10% of your deposit has increased by 9%, your overall result will be a profit. While, if you had all your deposit in Coin32, you would now look sadly at a larger loss.

To round up this section:

We have to spread our risk among different financial instruments. We should invest a small portion of our deposit in different coins.

This diversification is based on different financial markets, but there can be diversification on other levels as well: among different trading strategies, timeframes, different signal providers.

Please note that diversification is good when you use as markets and strategies that correlate as little possible.

By following these advices, you can use diversification as a really cool element in your long term strategy, helping you to minimize the risk in trading or investing.

Last point on today’s lesson: Stop-Loss Orders

What is a 'Stop-Loss Order'

Stop loss orders are orders placed sell (or buy) when a certain price is in the event that the market moved in the opposite direction than you expected. Stop loss orders were created to limit an investor’s loss on a position.

In the case when we talk about a long position (the trade started with a “buy” order) – the stop-loss will sell your coins at a price defined by you.

In the case of a short position (the trade started with a “sell” order) – the stop-loss will buy coins at a price defined by you.

Tell me more about ‘Stop-Loss Orders’

By using stop-loss orders, you take out emotions from your trading decisions and you replace them with strategy. It is also a useful tool for someone who is not watching the charts 24h per day.

The disadvantage of a stop-loss order is that its execution is not guaranteed. In case the market makes a sharp deep move down (or up), certain exchanges are not able to process the order at the marked price and they just skip it. This is because when a stop-loss order is placed, the exchange waits until that price gets to the stop price, and then sets an order that will be filled the next time the price visits that value. In a sharp drop (or raise) the price may not return anymore to the same value and the order is not filled.

Even with this risk, stop orders are a really cool instrument which you must use in order to avoid big problems and keep your deposit to a workable value. If you use stop orders together with proper money management, it is very difficult to reach a 0 level with your deposit – or as we say, to blow up your money.

With this instrument, you will have to make a lot of mistakes or failed trades in order to severely damage your deposit. I strongly recommend to use stop orders with all the signals we provide. Even if our statistics and reputation will be damage by not having only green streaks of profitable trades, by using stop-loss orders, you will save your money in the times when markets give a lot of fake signals.

We will talk about how to use stop orders and which levels must be taken for placing stop orders, later, when we will be studying Technical Analysis.

When can I trade without stop-loss orders?

You can trade without stop-losses only when all the conditions below are met:

• only on crypto markets like coin/usdt (fiat)
• only when you open long positions
• only on markets which has potential for upward movement in long run
• only when you use very small trade volume
• only when you are ready that this trade can become long term investment
• only when you realize and take all the risks

In other cases, you MUST use stop loss orders.

As a conclusion, I would like to emphasis that following proper Risk Management and using Stop Orders, you move yourself on the next level as a trader. It is obvious that many people are just playing in the financial markets as in a casino, and they don’t pay attention to these instruments. But you now gained the knowledge to use these tools in practice. If you will do that, then you chose the right road which will lead you towards your goals.

Key takeaways from this lessons

• Proper risk management is the key to profitable trading
• Risk management will help you keep a working deposit when the markets reverse and allow you to participate in new opportunities
• Perform risk analysis before starting a trade to set up your trade strategy
• There are no 100% perfect reliable signals
• Trade with volumes with which you are comfortable to be at a loss
• Use diversification to reduce your risk by spreading your trades in different pairs
• Use stop losses to eliminate feelings from the decision of exiting a trade

The next lesson will be about maximizing your profit. This means, we will be talking about Money Management.

If you have questions about Risk Management, please, leave them in comments.