Crypto Trading 101: Risk

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INTRODUCTION

Risk management is the process of identifying, assessing & mitigating threats to one’s assets. 

Investing in cryptocurrency markets always involves risk. Crypto markets are especially volatile. Whilst this risk cannot be entirely eliminated, it can be mitigated by implementing a proper risk management process. In this article, we’ll look at common risks in the crypto market, examine why risk management is essential & understand how traders typically protect themselves while trading.

SUMMARY

• Volatility, regulation, and technology risks are key factors to address when trading crypto.
• Improper risk management, or the complete absence of any risk management process, may significantly increase the probability of catastrophic losses - like losing all of one’s funds.
• An active approach that combines various aspects of risk management can help traders safeguard their funds. This includes sensible position sizing, using cold wallets and using tools like Arkham to track the broader market. 
• The nature of risks in the crypto industry are evolving over time, as the market matures and mainstream adoption increases.
  

WHY DO YOU NEED TO MANAGE RISKS WHEN TRADING CRYPTO?

Many crypto traders aren’t willing to put in the time & effort to enact proper risk management - they’re frequently fuelled by over-optimism, a desire for quick gains, and complacency. However, it only takes one careless lapse in judgment to cause significant financial losses. History has shown us that even the most successful crypto traders are not immune from the perils of improper risk management. The crypto hedge fund Three Arrows Capital (3AC) notoriously went from $18 billion in assets under management (AUM) at peak, to bankruptcy in 2022, arguably due to poor risk management of high leverage in their trading. Thus, the absence, or application of poor risk management doesn’t just expose a trader to moderate losses - it could mean losing everything.

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WHAT TYPES OF RISKS ARE THERE IN CRYPTO TRADING?

VOLATILITY

The most visible risk when trading cryptocurrencies is the substantial price volatility exhibited by this asset class. The creation of new tokens is very simple: often these will have low liquidity, and so can increase in price with a relatively low amount of buying pressure. Moreover, ambiguity surrounding use cases for certain tokens means that some trading activity in the digital asset space completely disregards fundamental factors, like user growth or the team’s background. Cryptocurrency markets are also traded 24/7, and easily accessible to participants all over the globe.

This high volatility makes crypto highly attractive as a vehicle for speculation, which can drive further volatility - a phenomenon known as reflexivity. Retail traders in particular see volatility as an opportunity to double their money in a very short period of time - something that would be challenging in traditional markets. However, this also presents substantial downside risk. An example of this was the infamous collapse of Terra Luna in May 2022. In just a week, the price of the cryptocurrency plummeted to 0, wiping out over $30 billion in market capitalization.

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REGULATORY RISK

Speculation is not the only source of price volatility, however. Another risk for crypto traders is the uncertainty surrounding regulation of digital assets, and the extent to which it varies around the world. Some countries such as El Salvador have adopted Bitcoin as legal tender; others such as China have banned it completely. When policies are implemented suddenly, traders are often caught off-guard & react simultaneously to new regulation: this may move prices more than in typical market conditions.

TECHNOLOGY RISK

The technology that underpins cryptocurrencies has pioneered decentralization, immutability and transparency - yet it is also a source of potential risk. Whilst traditional banking networks are controlled by a centralized party, this makes it more feasible to censor fraudulent transactions and retrieve hacked funds. However, blockchains generally have no central entity that can guarantee the recovery of hacked funds. Smart contracts are particularly vulnerable to bugs in code: they are designed to execute automatically when specific conditions are satisfied, without the need for human intervention. Once deployed on the blockchain, they are often immutable, so any vulnerabilities in code are more challenging to rectify. The discovery of smart contract bugs can allow malicious actors to manipulate the contract's intended operation and steal funds. To date, 20 exploits of over $100 million each have stolen funds from various bridges, protocols and exchanges.

PROJECT TEAM BEHAVIOR RISKS

Fundamental investors often buy into cryptocurrency projects on the basis of certain assumptions, including technological innovation, clear utility, and long-term user adoption potential. However, the success of a cryptocurrency project is also affected by the path taken by the team. Often, it is difficult to predict which route they will decide is best for the project, and the fast-changing nature of the industry can make this uncertain. A lot of tokens increase in value on hype & promises to deliver a product. If a team fails to follow through, attention can shift quickly away from the token, and price may be affected, Furthermore, individual catalysts may cause investors to fear the future of the project diverges from the initial expectations that their decisions relied on. For example, on 6th March 2022, Fantom fell by over 15% in just a few hours, following an announcement that Andre Cronje, a Cofounder, would be leaving the Fantom team.

MACRO RISKS

Additionally, factors in the broader economy can also catalyze volatility in cryptocurrencies. Through 2022, the Federal Reserve raised interest rates at the fastest pace in history in an effort to combat inflation. With the cost of capital increasing, investor confidence in more speculative asset classes like cryptocurrencies decreased. Their risk appetite had been lowered compared to in the bull run, so traders sold assets for  those with lower perceived risk and higher stability, such as the US dollar. Moreover, the shaky macroeconomic environment caused assets such as stocks, bonds and gold to decline through the year. Cryptocurrencies can at times exhibit strong correlations to these traditional assets.

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EXCHANGE RISK

Centralized cryptocurrency exchanges are the primary platform that traders and investors use to trade digital assets. They rely on a central intermediary to facilitate transactions and provide custody of assets. However, by storing your assets on the exchange, you relinquish control over your private keys, and therefore open yourself up to another type of risk, typically referred to as ‘exchange risk’.

A centralized exchange (CEX) can be especially vulnerable to hacks, since their custodial wallets hold a large amount of assets in a concentrated handful of wallets. A lack of transparency regarding their financial health can incentivise embezzlement, and could even lead to insolvency as users are unable to withdraw their funds. Additionally, a lack of regulatory oversight could make it easier for malicious actors in the space to engage in fraudulent practices. FTX for example, improperly lent customer funds to its sister organization Alameda Research & famously collapsed in 2022 due to a liquidity crisis. The famous crypto adage "not your keys, not your coins" cautions investors against the risks of storing their assets on a centralized platform & exposing themselves to these risks.

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LEVERAGE RISK

Leverage traders face additional risks in crypto markets. They must maintain a minimum amount of margin to keep positions open in their account. If the value of collateral falls below this amount, the trader faces the risk of liquidation, where the exchange forcibly closes their positions for them. This will generally happen if the market moves against them sufficiently.

For example, a trader with a 20x leverage short position in ETH will be liquidated if price moves upwards by 5%. This is a significant source of risk during periods of high volatility, in which a trader's portfolio can be wiped out in a matter of minutes. The combination of high leverage and volatile markets is particularly dangerous for inexperienced retail traders.

LIQUIDITY RISKS

The liquidity of an asset is your ability to buy or sell an asset without significantly affecting its price; its nature in the crypto market makes it a particularly unique risk in the asset class. Traditional markets largely operate on a centralized limit order book on a single exchange, which provides a high degree of consolidated liquidity. However, the cryptocurrency market lacks standardization, with numerous centralized exchanges offering their own order books to trade on. Moreover, the innovation of automated market makers (AMMs) has allowed the development of decentralized exchanges (DEXes). This results in fragmentation of liquidity across various trading pairs and exchanges, meaning large trades move the price of an asset more than in traditional markets.

How does this pose a risk to the smooth functioning of the crypto markets? Firstly, it exacerbates periods of high volatility: traders trying to simultaneously exit their positions might  lead to a further deterioration in liquidity. Furthermore, the decentralized nature of AMMs can lead to vulnerabilities, including the draining of liquidity from a pool: consequently, participants may struggle to swap tokens without incurring significant price slippage. Finally, abrupt changes in liquidity can arise from the removal of certain pairs, in order to comply with new regulation. This is because delisting restricts access to these coins, which hinders the flow of funds into and out of that coin, as traders find it less accessible for buying and selling. For example, on the 26th of October 2023, Binance announced they would be delisting several margin trading pairs, including ATOM-BUSD, UNI-BUSD, and XTZ-BUSD.

PSYCHOLOGY AND EMOTIONAL RISKS

The impact of one's emotions when trading crypto is an overlooked risk, but can often be the most dangerous one. For example, emotional traders may have a strong aversion to losses, which makes them reluctant to exit losing positions. These losses can compound until the trader has no choice but to exit their position at a huge loss. Moreover, a string of winning trades can lead to a false sense of security. Due to recency bias, the trader might become complacent and think they will never lose, thus may ignore protective risk management methods. 

This may be amplified by the use of excessive leverage, fuelled by greed and the prospect of increasing profits on winning trades. Thus, the allure of quick gains in the highly volatile cryptocurrency markets often leads traders to abandon risk management altogether. This is perhaps the largest risk of all, as a lack of risk management raises the chances of being wiped out completely.

HOW DO YOU MANAGE RISK IN CRYPTO TRADING?

We now focus on our attention on actionable strategies that can help us to mitigate the aforementioned risks when trading crypto.

POSITION SIZING

Many successful traders and investors have a strict framework they follow when determining how to manage their risk. A common rule is to limit the maximum risk taken per individual trade to a fixed percentage of their portfolio (for example, 3%) which will mitigate the impact of high price volatility. Traders do this to avoid betting too much of their money on one specific idea, even if they're confident of the outcome - markets have an inherent degree of randomness, so it's important to protect against unforeseen developments. This ensures the trader is able to recover from even the most extreme market crashes, which is an essential part of a sustainable investment strategy.

A simple technique to implement this when trading on a centralized exchange is through the use of a stop loss, which triggers the automatic exit of a position when the market moves against a trade by a certain amount. This ensures that the trader does not sustain a larger loss if price continues to decline below a certain price, thus allowing them to establish a predetermined maximum loss for the trade. It additionally provides protection against unpredictable price swings, like those catalyzed by unexpected news announcements. Moreover, it removes the emotional aspect from the decision-making process. This clear, pre-decided exit strategy helps cultivate psychological discipline: sticking to a risk management plan in this way may help the trader avoid making impulsive trading decisions.

HEDGING

Crypto traders can use a wide variety of financial products to hedge: that is, to try and reduce the effects of adverse price movements on their positions by taking other positions. These include products on centralized exchanges (such as Bitmex for perpetual contracts and Deribit for options) as well as on-chain protocols (such as GMX for perpetual futures, and Lyra for options). 

Hedging using these instruments can provide a great deal of flexibility and can offer ways to mitigate various risks, like those from events or changing regulation. For example, let’s say that you own 1 BTC, but are concerned about an ongoing lawsuit that may affect its price negatively over the next several weeks. You can purchase a put option with an expiry of 2 months from now as a hedging instrument. That way, any negative price movement in your BTC position as a result will be to some degree offset by an increase in the value of your put option.

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COLD STORAGE

Any crypto wallet that is not connected to the internet is considered ‘cold storage’. These include: 

• Hardware Wallets: Physical devices specifically designed for the secure storage of cryptocurrencies.
• Paper Wallets: A physical document that contains a public address for receiving cryptocurrencies, along with a private key for transferring them. 
• Multisig Wallets: These require multiple private keys to authorize a transaction. Often, at least one of these keys is kept offline, adding an extra layer of security.

Moving assets into cold may help mitigate multiple risks at once. The primary benefit is through reducing exposure to the exchange related risks we discussed above, as a portion of one's holdings remain intact even if an exchange they trade on experiences a breach. For example, let’s say you buy 1 BTC on an exchange for $30,000. Instead of leaving it all on the exchange, you can send 0.7BTC to a cold wallet, and reduce your exchange risk to 0.3BTC. 

Additionally, cold storage devices are air gapped, unlike hot wallets which are connected to the internet. This reduces the risk of cyberattacks through malware, especially when used with a hardware wallet that requires another level of authentication. Finally, the use of cold wallets can act as an effective psychological barrier for market participants. Investors must deliberately access their cold storage, which reduces the temptation to react emotionally to short-term market fluctuations. This encourages more rational decision-making and ultimately promotes a more measured approach to risk taking.

DUE DILIGENCE

One of the risks we mentioned earlier was holding tokens that no longer are reflective of your investment thesis. To counter this, it can be helpful to stay on top of news and developments related to cryptocurrencies in your portfolio. This can help you identify changes in the project's codebase, leadership, and community engagement. In particular, keeping up to date with things like governance proposals and on-chain activity may help ensure that your investment objective still aligns with a project's current roadmap. All of these actions constitute ‘due diligence’ - or background checks on a project’s multiple aspects.

Additionally, many investors want to make sure that the supply of tokens is not heavily concentrated in a small number of wallets. Such tokens may be less likely to be volatile, as any single individual selling all of their supply will have less of an impact on the token’s price. Arkham shows you the top holders of a specific token through the platform’s token pages, allowing you to assess whether a token is sufficiently decentralized and wouldn’t be subject to a significant market move from one person or entity’s actions alone.

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Analyzing an influencer's token holdings and historical activity using Arkham provides context for their incentives when promoting certain tokens. This allows you to make more informed decisions when trading crypto.

To conclude, a well-constructed risk management strategy will ultimately rely on individual factors. Most notably, risk tolerance will vary between investors: institutions have mandates that place restrictions on the type of assets they can purchase, as a condition of the investment they receive. Consequently, they can be legally required to limit investments in individual coins (or cryptocurrencies as a whole) to a certain percentage of their portfolio. Therefore even funds with the highest level of exposure to cryptocurrencies may be more risk-averse than retail traders.

IS CRYPTO A HIGH RISK INDUSTRY?

One of the primary challenges for institutional participation in crypto markets has been the space’s volatility. This makes it harder for institutions to establish a predictable risk profile, which is a crucial element in their investment strategies. Furthermore, institutions are subject to strict regulatory mandates designed to protect consumers and prevent illicit activities such as money laundering and fraud. The unpredictability of regulatory change, and its variability between jurisdictions, may have made it more challenging for institutions to participate in this market.

Nevertheless, the cryptocurrency market is young compared to its traditional counterparts. With the passage of time, it may be that volatility will decrease and regulatory frameworks for fund participation will be adopted.

Many high-growth, disruptive industries have been considered risky in their nascent stages. However, major crypto stakeholders are making efforts to address the apparent risks over time as the crypto industry recognizes and reacts to them.

CONCLUSION

Ultimately, proper risk management is essential for traders to conserve their capital & avoid losing an excessive amount of money. While trades always involve a degree of risk & even the top traders won't always get their trades correct 100% of the time, a robust risk management strategy will allow a trader to deal with the risks inherent to crypto trading. Price volatility, regulatory uncertainty, and technological vulnerabilities are the most visible risks to participants. However, the impact of emotional decision-making is arguably the most dangerous one, as it significantly increases the risk of substantial losses. As the cryptocurrency market continues to evolve, so does the need for proactive risk management, which will allow investors to navigate uncharted waters with greater security and conviction in their decisions.