Common risk management strategies
There is no single way to approach risk management. Investors and traders often use a combination of risk management tools and strategies to increase their chances of growing their portfolios. Below are a few examples of strategies that traders use to mitigate risks.
💡 1% trading rule
The 1% trading rule (or 1% risk rule) is a method traders use to limit their losses to a maximum of 1% of their trading capital per trade. This means they can either trade with 1% of their portfolio per trade or with a bigger order with a stop-loss equal to 1% of their portfolio value. The 1% trading rule is commonly used by day traders but can also be adopted by swing traders.
While 1% is a general rule of thumb, some traders adjust this value according to other factors, such as account size and individual risk appetite. For instance, someone with a larger account and conservative risk appetite may choose to restrict their risk per trade to an even smaller percentage.
💡 Stop-loss and take-profit orders
Stop-loss orders allow traders to limit losses when a trade goes wrong. Take-profit orders ensure that they lock in profits when a trade goes well. Ideally, stop-loss and take-profit prices should be defined before entering a position, and the orders should be set as soon as the trade is open.
Knowing when to cut losses is essential, especially in a volatile market where prices can tumble rapidly. Planning your exit strategy also prevents poor decision-making from emotional trading. The stop-loss and take-profit levels are also essential for calculating the risk-reward ratio of each trade.
💡 Hedging
Hedging is another strategy traders and investors use to mitigate financial risk. It consists of taking two positions that offset each other. Simply put, traders can hedge one trade by making an opposing trade of similar or equal size.
It may seem counterintuitive to enter positions in opposite directions, but if done properly, hedging can reduce the impacts of a market move. For instance, imagine that you are long BTC and holding it in a personal wallet. If the market enters a downtrend, you could take a short position to offset your long position without having to move your BTC. This is what we call a market-neutral strategy.
💡 Diversification
As the old saying goes, you should not put all your eggs in the same basket. In other words, diversify your portfolio. In theory, a well-diversified portfolio offers more protection against massive losses compared to a portfolio made up of only one single asset. If you hold a crypto asset in a diversified portfolio, the maximum damage you would receive if its price tumbles is a percentage of your portfolio. On the contrary, if your portfolio is completely made up of a single asset, then you could potentially lose 100% of your portfolio’s value.
💡 Risk-reward ratio
The risk-reward ratio calculates the risk that a trader will be taking relative to the potential reward. To calculate the risk-reward ratio of a trade you’re considering, simply divide the potential loss by the potential profit. So if your stop-loss is at 5% and your target is at 15% profit, your risk-reward ratio would be 1:3, meaning that the potential profit is three times higher than the risk.
