Trading Risk with Bitcoin

Risk management is a very important element in trading of any duration, whether that be with short term trades of something, long term investing, or anything in between. Investors tend not to focus on it very much, and they may be able to get away with this if they are taking long term views and are playing the trends we’ve seen in this time frame over the years. The paper losses that occur along the way are unrealized as long as they stay in the position, and they may be seeking to just hang on long enough for the trend to manifest, where the dips along the way are just seen as part of the journey.

This does not mean that long term investors need to not pay much attention to risk management, and in fact, even with a very long-term perspective. It is not preferable to be down a lot with your portfolio, or to experience big moves against you and not attempt to manage these moves.

Trading Risk with BitcoinInvestors are still exposed to the risk of needing to sell their positions and realize the risks that are present, and there’s also of course the prospect that these long term up trends won’t be present during a particular investor’s long-term time frame.

The higher the potential that one would be closing their positions and realizing losses that result from risk exposure, the greater the importance of managing these risks. The time to be thinking about this isn’t after it has happened, like for instance how the great majority of investors approach risk for the most part, because at that point it is too late and what needs to be avoided has already occurred.

We instead need to focus on risk management, keeping our level of risk comfortable, before we enter a position, where we set controls that we are going to be using throughout the holding period. These risk controls consist of a set of rules and objectives that will seek to protect us from being exposed to excessive risk.

Risk Management and Trading

The shorter the term that we expect to hold our investments with, the more significant risk controls become, because the shorter we hold something, the more likely we are to realize losses from risk exposure. While the long-term investor may just sit back and wait out adversity, and therefore not sell and realize the losses flowing from the adverse movements, those who trade certainly will.

When we trade, we cannot just ignore risk and get away with it in the same way that a long-term investor might, or at least we cannot do this and hope to be successful trading. The main reason is that with trading, our profit objectives will be smaller, and we cannot limit our objectives without limiting our losses as well.

Many traders have been undone by ignoring this principle just once, where they refuse to close a position when they should, and hang on to it through enough of a storm that their account gets decimated and their ability to make money on further trading severely handicapped, or worse.

If you lose 50% of your trading account, you have to realize a 100% gain just to get back to where you were, and even a drawdown of 25% requires a gain of 33% to get even. It simply costs more to lose than it benefits you to win, percentage wise, and a 10% loss and a 10% gain for instance is not equal in all respects.

Since you always have to see a bigger return to make up for a given percentage loss, this makes managing potential drawdowns even more important. This is one of the reasons, although not the only one for sure, why risk management is even more important than returns with trading.

Trading is often leveraged, which ends up increasing the volatility of the trade by the percentage leveraged. If you are leveraging your trade by 4 times that means 4 times the volatility, and so on in accordance with the multiplier.

The Greatly Increased Risk of Trading Bitcoin

Volatility multiplies the concerns of risk management, and is the real reason why leveraged trading requires much more care. This is not to say that leveraged trading or trading a highly volatile instrument is too dangerous or in any sense a bad idea, but it certainly is if we do not employ sufficient risk management appropriate for the situation.

While there are many reasons why so many traders struggle and end up failing, poor risk management is certainly one of the big ones. If we don’t pay proper attention to this, even if we are otherwise a good trader, we are headed for trouble and often a huge amount of trouble.

What distinguishes bitcoin trading is its massive volatility, and even though it has calmed down a lot from the period from the fourth quarter of 2017 and the first quarter of 2018, where it saw a tremendous runup followed by a very significant fall, going from about $7000 to almost $20,000 and then back to $7000 in a matter of just a few months, it still is pretty volatile and will likely remain so.

This calmer period still can see bitcoin move 25% in either direction in just a couple of weeks, so this might be calm compared to where bitcoin and other cybercurrencies have been in the recent past, but this is by no means a calm trading vehicle by trading standards.

There is still nothing remotely comparable to the amount of volatility involved in trading something like bitcoin or other major cryptocurrencies, which have established an entirely new definition of trading volatility and trading risk. There is more money to be made here and more money to be lost trading bitcoin and we want to be much more careful and much more confident about what we are doing when seeking to trade it.

Those who take a more conservative view of trading, including many traders, see something like bitcoin as having qualities that are simply too inherently risky, and given how much it can still move, this is understandable.

However, with the right technique, even very high risk can be managed, and it’s even possible to manage the trading risk with bitcoin even with leveraged positions if done right. This isn’t even necessarily more challenging provided one uses the proper controls, which in the case of leveraged bitcoin will have us not sticking around for very long when things move against us.

Bitcoin Risk Management in Practice

We can define the risk of a trade however we want, including setting it as a very small percentage of the overall value of our position. Successful traders for instance will typically set their risk appetite at 1% or 2% of their position, where for instance if one bought $10,000 of bitcoin, a loss of more than $100 or $200 would have us exiting the trade, where our stop loss level would be hit.

This does not mean of course that the trade would always be held to hit these stops, as there are other factors that may influence how long we stay in it, the movement of technical indicators for instance. When we define our risk by setting such a maximum percentage loss, this just means that this is the most we are prepared to lose with it.

The trick to all this though is to manage risk properly while still striving for acceptable returns, although sufficient risk control is an absolutely necessary component of this, and that part needs to be seen as unalterable.

In order to accomplish this, we’re going to have to really limit our time frames with bitcoin, in the same manner that we would seek to manage highly leveraged positions with things like trading futures or contracts for difference.

Many traders do very well with trading leverage as high as 30:1, where if the underlying asset moves 1%, one’s position moves 30%, which is a lot of volatility indeed. By looking to ride waves of momentum and exiting when things don’t turn out as hoped, and exiting quite quickly, a good trader can realize very good rates of return, several times greater than just holding the underlying asset would provide, while reducing rather than increasing risk.

This is all dependent upon a trader having a good plan that does tend to win more money than it loses, and that’s what is missing from less successful traders. Coming up with a profitable trading plan independent of risk is essential, and at some point, every trader who is going to last very long needs to achieve this.

From there, what we do with risk management is to ensure that our profitable trading ideas can be allowed to drive our returns in a way that doesn’t involve excessive drawdown, so that the probabilities of the system can be allowed to play out without our getting into situations where meaningfully higher rates of return are needed to make up for the effect of these drawdowns, for instance, our needing 100% to make up for a 50% drawdown.

Trading bitcoin is similar, especially now that its volatility has calmed down, and in spite of it being still very volatile, this can be managed if approached correctly in the same way that futures trading can be managed by skilled traders.

The level of skill with bitcoin trading is higher though, due to its spreads being nowhere near as desirable as you can get with futures trading or through a good contracts for difference broker.

These larger spreads impact both the challenge of coming up with a profitable system and the amount of risk involved. When we are behind more when we enter the trade, this amount is added to the risk of the trade from the outset.

We’re going to have to not only manage this by setting tighter stops, we’re also going to see our profit potential decreased by this, profit that would normally offset the losses we incur. So, larger spreads affect both, and both of these elements affect the degree of risk in the trade, as when we make less there is more risk for drawdowns as they are not being offset as much.

With all this said, bitcoin is a pretty unique asset to trade and we don’t just want to allow larger spreads to scare us off, even though larger spreads are significant indeed to trading, especially the short-term trading that we must use if we plan on managing the risk of something like bitcoin.

We always need to not only test our ideas out prior to putting real money on the line, we need to make sure that trading a certain asset like bitcoin delivers good enough results over whatever else we may be trading instead to make sense of trading bitcoin.

If we can achieve this, and if we can manage the risk well enough, trading bitcoin can indeed prove worthwhile.

Andrew Liu


Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.

Contact Andrew: [email protected]

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