Cryptocurrencies are often considered to be volatile and trading them can sometimes be risky. The crypto market has also been known to experience price swings, and like every other investment, there is the chance your investment may sink in value, irrespective of how sure-shot things may seem. That said, risk management is undoubtedly one of the most important aspects of investing in cryptocurrencies.
Here are some ways to manage crypto risk.
Only invest what you can afford to lose
As with any investment, you should never invest more than you can afford to lose. This rule applies to all markets and even more so to cryptocurrencies, which can experience double-digit losses in a span of hours.
There’s no doubt that cryptocurrencies have turned several early investors into millionaires. But at the other end of the spectrum, they have left a number of novice investors in financial peril. Apart from the fact that these assets can quickly lose their value in response to ever-changing government policies, crypto trading platforms can fall victim to a hack or shutdown operations.
In 2021, dozens of people in Singapore filed police reports against a crypto trading platform called Torque. A rogue employee of the company reportedly performed unauthorized trading activities that led to significant losses and customers were restricted from using the platform.
Optimism can affect rational decision-making during market peaks, but it’s important to avoid getting caught up in the hype cycles and unsubstantiated promises. Think before investing your life savings or selling a property to buy crypto.
Move your crypto assets into cold storage
You’ve probably heard this saying from crypto folks: “Not your keys, not your coins.” Storing your assets on a centralized exchange can come with a number of risks, like site crashes, hacks and even bankruptcy. Crypto platform FTX halted withdrawals and filed for bankruptcy in November 2022, dragging much of the crypto industry down with it as it crumbled.
Transferring crypto assets to a cold storage device can mitigate some of the risks associated with trusting a centralized exchange to safeguard your funds. To clarify, a cryptocurrency exchange holds your private keys and therefore controls your assets. Cold storage, on the other hand, gives you full custody over your assets. Moreover, cold storage devices are not connected to the internet, which drastically decreases the ability of hackers and cybercriminals to access your funds. Some of the most popular cold storage devices are hardware-based and come from companies like Ledger and Trezor.
Hedge your crypto portfolio
Hedging has long been used in traditional financial markets as a form of risk management. It involves buying or selling an asset to potentially help reduce the risk of loss of an existing position or adverse price movements in an asset.
It is worth mentioning that although hedging allows you to protect your investment from adverse market swings, it also limits the potential gains from your crypto investment. Nevertheless, this is a better option than losing a significant portion of your investment.
The “Dollar Cost Averaging” (DCA) strategy is one of the simplest ways to hedge a crypto investment. It entails incrementally buying or selling crypto at regular intervals rather than deploying capital in one large purchase or selling one’s entire holdings at once.
For example, let’s assume you have $1,000 to invest in Bitcoin. Instead of purchasing $1,000 worth of Bitcoin in one fell swoop, you can split your investment into $250 every week spread across a month. While you might lose some potential gains if the price of Bitcoin shoots up after your initial purchase, you’d have also saved yourself from potential losses if the price crashes.
Diversify your portfolio
When it comes to crypto or any other investment, avoid putting all your eggs in one basket. In May 2022, the price of algorithmic stablecoin terraUSD (UST), which was supposed to be pegged to the U.S. dollar, fell to 35 cents. A few days later, its accompanying cryptocurrency, LUNA, plunged from $80 to a few cents.
Do not invest in only one cryptocurrency, regardless of your conviction. Instead, spread your investment across several digital assets. You can diversify your crypto holdings by investing in projects based on their use case or technology. For instance, Bitcoin has been touted as a store of value and might be a good way to preserve wealth. Ethereum, on the other hand, has become the largest platform for decentralized applications and smart contracts. Meanwhile, a stablecoin’s value is pegged to an underlying asset, making it typically less erratic than other digital assets. It’s good to remember that there are hundreds of cryptocurrency projects trying to achieve different things.
Avoid excessive leverage
This is more of an advanced tip, but you’d be shocked at the number of beginner traders that try to margin trade. Margin is used to increase the order size and gives you the option of going long or short. Some crypto exchanges may offer leverage as high as x100.
While the idea sounds good in theory, a 1% move against you could wipe out your entire portfolio. You could lose your entire principal during a forced liquidation.
A safer approach would be sticking to lower leverage amounts, which provide more room to not only increase your gains but also a buffer zone to exit a bad trade.
As with any investment, risk is a part of the cryptocurrency trading experience and cannot be entirely removed. Rather than assume that everything will go as planned, a smart trader identifies risky areas and finds a way around them.