Risk Management Guide for Crypto Derivatives Trading
The crypto market has seen exponential growth, with the total market capitalization reaching highs close to $3 trillion back in 2021, before falling below $1 trillion and recovering to $1.68 trillion in 2023. Price fluctuations are a defining characteristic of an inherently volatile crypto market, which is a double-edged sword that can lead to substantial gains as well as significant losses. Even Bitcoin (BTC), perceived as a stable, leading cryptocurrency, can experience dramatic price movements, swinging from $60,000 to $30,000 and vice versa within just a few months during bull and bear runs.
In this volatile environment, the importance of risk management cannot be overstated. Effective risk management strategies are crucial for anyone looking to engage in crypto derivatives trading. Without a solid risk management plan in place, both new and experienced traders are at risk of massive capital loss, which can occur swiftly due to rapid market shifts.
What Is Risk Management?
Risk management refers to the identification, analysis, and mitigation of uncertainties in investment decisions. In the context of crypto derivatives trading, it refers to the use of strategies and tools to minimize potential losses and safeguard investments from the unpredictable price movements of crypto assets.
Effective risk management in crypto is all about maintaining a balanced portfolio and making informed trading decisions. Whether you are a new or experienced trader, risk management in crypto is crucial for several reasons:
Preserving Capital:
Effective risk management can help keep your losses minimal, predictable, and part of your strategy. It also helps you avoid cases where a black-swan event or unforeseen price fluctuation wipes out your account.
Emotional Control:
It helps you remain calm and rational, preventing impulsive decisions driven by fear or greed.
Sustainability:
Proper risk management can potentially allow you to sustain your trading activities over the long term.
Example of effective risk management in action:
Consider a trader during the May 2021 crypto crash. Suppose the trader has a portfolio heavily invested in Bitcoin (BTC). As the market starts to decline, the trader sets a stop-loss order for BTC at 10% below the current price of $50,000 to limit potential losses.
Without a risk management strategy:
If BTC drops from $50,000 to $30,000, the trader would incur a substantial loss of $20,000 per BTC. This drastic drop could potentially wipe out a substantial portion of their investment, leading to severe financial strain and stress.
With a risk management strategy:
With the stop-loss order set at $45,000, the trader's BTC is sold when the price hits this threshold. This action limits the loss to $5,000 per BTC, protecting the trader from further declines as BTC continues to plummet to $30,000. This preserves a considerable portion of their capital, allowing them to reallocate funds more effectively or wait for the market to stabilize before reinvesting.
By implementing stop-loss orders, one of the many risk management strategies, the trader mitigates the impact of the market downturn and is able to reassess the situation to put funds towards other, more profitable crypto assets.
Key Indicators to Assess Risk in Crypto Derivatives Trading
Crypto derivatives trading can be complex, with various factors capable of influencing the price movement of a specific asset. To make informed trading decisions, it's essential to review these key indicators to help determine the potential risk involved before you open a position.
Funding Rates
Funding rates are periodic payments made between long and short positions in crypto derivatives trading to keep the contract price close to the underlying asset's price. They are essential for maintaining the price alignment between perpetual contracts and the spot market.
Example: If the funding rate for a Bitcoin perpetual contract is 0.01% and the trader holds a long position worth $100,000, they would pay $10 every eight hours to the short position holders. Understanding and anticipating funding rates can help traders manage their costs and optimize their trading strategies.
Using Flipster for your crypto derivatives trading? Learn more about funding fees on Flipster.
Liquidation Price
The liquidation price is the price level at which a trader's position is automatically closed by the exchange to prevent further losses that could exceed the trader's margin. This is a critical metric for managing leveraged positions.
Example: If a trader opens a 10x leveraged position on Ethereum (ETH) at $3,000, and the maintenance margin requirement is 10%, the liquidation price will be around $2,700. If Ethereum's price drops to this level, the position will be liquidated to prevent further losses. Monitoring the liquidation price helps traders manage their leverage and avoid unexpected closure of positions.
Learn about mid-price, mark price, and how they affect liquidation on Flipster.
Volatility
Volatility measures the price fluctuation of an asset over time. In the context of crypto derivatives trading, high volatility can lead to considerable profits but also poses substantial risks.
In assessing risk, traders often use advanced metrics like the Volatility Index (VIX), commonly referred to as the "fear gauge" in traditional markets. Although the VIX specifically applies to stock markets, the concept can be adapted to cryptocurrencies. A volatility index for crypto, such as the Crypto Volatility Index (CVI), can provide a quantitative measure of market risk and investor sentiment.
Example: During the sharp market fluctuations in March 2020, the Crypto Volatility Index (CVI) experienced major spikes, reflecting increased market uncertainty and risk. Traders who monitored the CVI noticed these heightened volatility levels, which served as a warning signal of potential market instability. By integrating CVI readings into their risk management strategies, these traders could have adjusted their positions, implemented stop-loss orders, or used hedging techniques. Conversely, traders who ignored the CVI indicators were more susceptible to substantial losses as the crypto market underwent drastic price swings.
Trading Volume
Trading volume is the total number of shares or contracts traded for a specific asset within a given period. High trading volume often signals strong market interest and liquidity, reducing the risk of slippage and rapid price fluctuations.
Example: A high trading volume in Cardano (ADA) futures during a market rally indicates strong interest and better price stability for traders. Based on this, a trader might increase their position size and set tighter stop-loss orders due to the reduced risk of sudden, unpredictable price swings. Conversely, low trading volume might prompt a trader to reduce their position size and set wider stop-loss orders to account for higher volatility.
How to Minimize Risk in Crypto Derivatives Trading?
Effective risk management in crypto derivatives trading is essential for shielding your portfolio from downsides and achieving long-term success. Use these fundamental techniques and strategies to manage risk:
Set Up Take-Profit and Stop-Loss Orders
Take-profit and stop-loss orders are automated tools that allow traders to set predetermined exit points for their positions, ensuring that profits are secured and losses are minimized. Take-profit orders close a trade once a target price is reached, locking in profits, while stop-loss orders automatically sell an asset when its price drops to a certain level. This gives traders better control over their funds when they are not actively monitoring the market.
Flipster allows traders to easily set and configure take-profit and stop-loss orders via trigger orders.
Avoid Over-Trading
Over-trading can lead to losses due to increased exposure to market volatility and transaction costs. It's important to have a disciplined trading strategy that focuses on quality over quantity. By carefully selecting trades and avoiding impulsive decisions, traders can better manage their portfolios and minimize unnecessary risks.
Hedging
Hedging involves taking positions that offset potential losses in other parts of your portfolio. For example, you can use futures contracts to hedge against potential declines in your crypto assets. Typically, this strategy includes buying assets on the spot market while taking an opposite position in the futures market. For instance, if you hold Ethereum (ETH) in your portfolio, you might enter into a futures contract to sell an equivalent amount of ETH. This way, if the price of ETH falls, the loss in value of your spot market holdings can be offset by the gains in your futures contract. By doing this, you can mitigate the impact of adverse price movements on your trading portfolio, providing a form of insurance.
Flipster supports hedging strategies via perpetual swap contracts, allowing traders to hedge effectively and protect their investments.
Risk-Reward Ratio
The risk-reward ratio helps traders evaluate the potential return of a trade relative to its risk. A favorable risk-reward ratio ensures that the potential profit outweighs the potential loss, making trades more viable. For instance, a 1:3 risk-reward ratio means that for every dollar risked, there is a potential to earn three dollars. Incorporating this ratio into your trading strategy can help you make more calculated and profitable trading decisions.
Prudent Capital Management
Prudent management of capital involves determining how much of your portfolio to allocate to each trade and setting limits on how much you are willing to lose. This strategy helps preserve your capital and ensures that no single trade can have a serious impact on your overall portfolio.
On Flipster, traders can customize the amount they allocate to each order, allowing for precise control over trades. This helps set appropriate position sizes and limits based on individual risk tolerance and overall trading strategy.
Minimize Emotional Trading
Trading based on emotions like fear and greed can lead to poor decisions and significant losses. To minimize emotional trading, try maintaining a trading journal to review past trades, which can help identify any emotional patterns or triggers you might have.
Trade details: Date, time, asset traded, position size, entry and exit prices.
Rationale: Reason for entering the trade, adherence to your trading plan.
Emotional state: Emotions felt during the trade, any emotional triggers.
Outcome: Profit or loss, lessons learned.
Market conditions: Market sentiment, external factors impacting the market.
By keeping a concise and focused trading journal, you can better understand your trading behavior, refine your strategies, and make more objective decisions.
Be Disciplined
Discipline is the foundation of successful risk management strategies. Stick to your trading plan, set realistic goals, and avoid chasing losses. Consider setting predefined entry and exit points and stick to them to ensure consistency. Having routine self-assessments can also help you track whether you are adhering to your plan and achieving your goals. By maintaining discipline, you can create a structured approach to trading that mitigates impulsive decisions and promotes long-term success.
1% Rule
The 1% rule suggests that traders should not risk more than 1% of their total trading capital on a single trade. This is an effective risk management strategy that helps to limit potential losses and preserve capital over the long term.
Diversify Your Crypto Assets
Diversifying your investments across different crypto assets can help spread risk and reduce the impact of any single market event on your portfolio. By holding a variety of crypto, you can mitigate the effects of volatility and enhance the stability of your investment returns.
For traders, diversification also allows for more effective risk management and the ability to capitalize on opportunities across different markets. This strategy helps traders navigate market fluctuations and optimize their overall performance.
Flipster enables diversification by giving traders access to a wide variety of crypto assets, making it easier for traders to build a balanced and resilient portfolio.
Set Your Leverage to 1x
Using leverage amplifies both gains and losses. By defaulting to a 1x leverage, traders can avoid the heightened risks associated with leveraged positions, particularly in a volatile market like crypto. This conservative approach ensures that you only trade with the capital you have, avoiding potential margin calls and liquidations.
Flipster gives users the ability to set their leverage, defaulting to 1x but offering up to 100x when trading with margin, allowing them to control their exposure and manage risks more effectively.
Position Sizing and Margin
Proper position sizing and margin management are critical for controlling risk. Determining the size of your trades based on your risk tolerance and the available margin in your account helps ensure that you don't overextend your capital.
Flipster includes comprehensive guidelines for position sizing and margin management, supporting traders in optimizing their risk management strategies. For more insights, consult our FAQ on margin and position size.
Instant Flip
Flipster’s Instant Flip feature allows traders to quickly close their current position and open a new one in the opposite direction with a single tap. The initial invested funds for the new position will be based on the invested funds and realized profit or loss of the original position.
With Instant Flip, traders can quickly respond to market changes to manage risks and better maintain control over their trading strategies.
Trade With Confidence
Flipster's in-built risk management tools like stop-loss orders, take-profit orders, position sizing, empowers users to manage their risks effectively. Trade smarter with Flipster today.
Disclaimer: This material is for information purposes only and does not constitute financial advice. Flipster makes no recommendations or guarantees in respect of any digital asset, product, or service. Trading digital assets and digital asset derivatives comes with significant risk of loss due to its high price volatility, and is not suitable for all investors.