On Risk Management in Crypto

This post is mainly concerned with the risk management aspects of actively trading cryptocurrencies. Some of this may not apply if you have a super long-term investment horizon and plan to just hold on to crypto assets for years.

The most important thing in trading is protecting your downside. If you have any amount of money invested, you should have a risk management strategy that allows you to pursue the maximum amount of portfolio gains while reducing the risk you are taking as much as possible. Investing is all about going after opportunities that have a favorable risk/reward ratio.

Before taking any position, you should have thought about how much risk you are willing and able to take.

You have probably heard this 1000000 times but the amount of people I see gambling with money they absolutely cannot afford to lose warrants repeating it. If losing 100% of your crypto portfolio would force you to seriously change your lifestyle, you have invested more than you can afford. Having too much capital in extremely speculative investments (like crypto) will also make you a significantly worse trader. You will be more emotional, FOMO buy and either sell way too early or hold on to losing positions for way too long. The more emotionally distant you are to volatility and gains/losses, the better. If you are gambling with your living expenses, being emotionally distant is pretty much impossible.

Every great trader I know loses once in a while, the key is to lose small constantly but win big occasionally. Unless you are sitting in front of your computer the entire time your position is open, not setting any stop loss when margin trading is like driving a Lambo without brakes. Blindfolded. Backwards.

If you have a position that is is underwater, you should ask yourself whether you’d buy it at current prices. If you bought bitcoin at 10.000$ and it drops to 8.000$ you should ask yourself whether you’d buy bitcoin at 8.000$. If the answer is no, sell your position and pursue gains elsewhere or wait for market conditions to change.

This is especially relevant in the crypto space. In crypto, counterparty risk is the sum of all custodianship risk you take on by not storing private keys yourself and any other risks related to exchanges. I got stopped out a few weeks ago on BitMex because their site was down and I couldn’t move my stops. I am aware of the risk I am taking by trading on any exchange but I am willing to do it anyways. The important thing is being aware of the risk and determining how much of your total capital you are willing to risk.

Exchange down? Exchange hacked? Withdrawal limits? All of that is counterpart risk. Think about how much you tust a specific exchange or service and determine how much of your capital you are willing to put at risk. The easiest way to reduce counterparty risk is to store all crypto assets you are holding for the medium to long-term on a cold storage hardware wallet and only transfer assets to an exchange if you want to sell them.

If you are actively trading however, cold storage is not really a viable option for you.

The next best thing is to diversify your capital over a number of exchanges.

I try to spread my trading capital out over a couple of exchanges in order to mitigate the very real risk of one (or several) of them getting hacked.

Let’s do the math on this:

Let’s assume for the sake of simplicity that the probability “p” of an exchange getting hacked in the timeframe t is 1% (I know that the risk of an exchange getting hacked is almost impossible to quantify so 1% is completely random). If you store all of your trading capital (let’s assume that’s 10000$) on a single exchange, your risk per time unit t is 1%.

So the probability „p“ of the event that you lose all of your money in time t is 1%.

However, if you store 1/5 of your capital on 5 exchanges, you have a 1% risk of losing 2000$ dollars 5 times per t.

(2000*1%+ 2000*1%+ 2000*1%+ 2000*1%+ 2000*1%)*t

The probability of losing all of your capital when it is spread out over 5 exchanges is no longer 1% but 1%^5, or 10^-8 which is 0 for all practical purposes.

In investing, you have two distinct but related forms of risk; systemic and residual or specific risk. Systemic risk is the kind of risk that exists for the whole market. In crypto, one of the biggest systemic risk factors is regulation. If the US bans all cryptocurrency trading tomorrow, it probably wouldn’t matter whether you are holding Ethereum, Bitcoin or NEO. If the whole market crashes due to some unforeseen factors, that is systemic risk. Residual risk are all risk factors that are specific to one asset or a small group of assets. Some examples for residual risk factors are illiquidity, management and FUD.

How much systemic risk are you taking on by investing in crypto assets? How much more residual risk are you willing to take?

The total risk of any position is thus Systemic risk + residual risk + counterparty risk

In traditional finance, it is standard practice to quantify risk by equating it to volatility. In my opinion, that is intellectually lazy. For all practical purposes, volatility does not equal risk. You will never be able to accurately quantify risk but the important thing is to have considered it before making any investment.

As somebody much smarter than me whose name I couldn’t find said “The biggest risks are the ones you are taking without being conscious of it”

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