The Basics of Risk Management and Position Sizing in Cryptocurrency

Risk Reward: Risk Management, Position Sizing, Stops, and Warding off FOMO

Risk management and position sizing are important aspects of cryptocurrency trading and investing. It can be tempting to go all in or out. However, this can be a recipe for disaster given the volatile crypto markets.

Position sizing: The size of one’s buy or sell, or more generally total position in an asset or asset class, relative to their bankroll.

Risk management: Using tactics to manage risk such as position sizing and stop losses.

TIP: learn about market cycles and using stops and trailing stops. These two topics will help a lot with risk management.

Risk, Reward, and Statistics

General wisdom says that it is best to invest and trade using small amounts of your total investable capital set aside for cryptocurrency.

That wisdom is rooted in two general concepts: 1. risk / reward and 2. statistics.

Statistically, the larger your bid size, the more potential risk / potential reward per position. Reward is nice, but to ensure rewards over time it is vital to limit risk in the short term.

The reality is the risk of large bid sizes (relative to your total bankroll) outweigh the potential rewards statistically, over time, on average.

Consider, the difference between losing 50% of your bankroll twice in a row as opposed to doubling half your bankroll twice. In one case $100 turns into $25 (lose $50, which takes you to $50, then lose $25, which takes you to $25), in the other $100 turns into $225 ($50 the first time, $75 the second, plus the original $100).

If you turn your $100 into $25, getting back to $100 will be a real challenge, never mind getting to $225 from there ($100 is a 300% increase from $25; $225 is a 900% increase from $25).

Use 5% per bid instead, and you can afford to lose a few bets along the way (if you risk 5% of $100, you are risking $5; getting back to $100 from $95 takes an increase of about 5.264%).

Sure, it’ll take you more time to get to $225 using smaller bets, but statistically you’ll have many more opportunities to makes gains and avoid losses.

There will be more room for skill, and less reliance on luck.

There will be leeway for some mistimed buys, and there will be more opportunities for those crazy big wins that crypto offers every once in a while.

The above is true in investing, but is especially true in trading.

Further, the above is especially in cryptocurrency investing and trading, as the historic volatility means there are a lack of sure bets and lots of opportunities to lose 50% or more of a position on a mistimed entry.

The concept being, if you focus on mitigating risk, you’ll from that vantage point have room to fall on your face a bunch while striving for rewards.

That is a rough sketch of the basic logic, those points are discussed more below alongside further examples.

How does does one make money with small positions? In trading, it is a matter of setting stops to limit the downside of a trade (the upside is as high as the next run goes, the downside is limited by the stop). In longer term investing, for example in dollar cost averaging, it is creating a position out of smaller positions and then [ideally] selling it down the line for a profit when you are ready. With small bids each mistimed buy or stop hit only costs you a small amount. With large bids, mistimed buys can quickly erode your bankroll when trading or result in an unattractive average price in investing.

Mitigating Risk With Strategy

Details and examples of why risk management is important aside, a conservative strategy that mitigates risk might look like this (this being an example, not a suggestion):

  • Take 4% of your total investable capital and commit it to crypto assets (so say you have $100,000 to invest, use $4,000).
  • Never spend more than 1% – 2% of that 4% on one trade (so you are thus, in the example, making $40 – $80 trades).
  • Never make too many trades in a short time frame for long term investments (as that just mimics taking larger positions).
  • Consider averaging (AKA laddering) in and out of short term positions (you can average in and out with stops as well).
  • If you are day trading, use stops (raising your stops up to lock in profits). NOTE: The tighter the stop, the less capital is risked. With that said, where to place a stop has more to do with chart patterns than dollar amounts. Still, it helps to understand the risk you are taking in terms of dollars and percentages.
  • If you are investing for the longer term, have a plan for when you will enter and exit the market (for example, I’ll aim to spend 5% of my capital per month, making buys once every week, and will only exit when X conditions are met). For some the conditions will be based on ensuring against losses, for others the conditions will be about holding out for future gains and accepting losses on paper (that is a matter of goals and tastes).

On using stops and laddering: If you don’t keep positions sizes low, then you’ll have trouble strategically placing stops (because you’ll likely have to set them very tight to limit potential percentage losses). In general, stops should be placed based on chart analysis and not based on a percentage point, thus you’ll need to think about position sizing relative to your stop. If you would place the stop “far” away, consider laddering into the position instead of entering all at once. With that said, even a perfectly placed stop can get hit if big buy or sell orders happen to trigger it. People get stopped out all the time in crypto due to the lack of liquidity in some markets and the volatility in almost all markets. Thus, even a trader who only makes perfect plays on paper is at a risk of being stopped out in a “stop hunt.”

Putting Strategy and Reason Over Emotion to Avoid the Mistakes Most People Make

That is a very conservative version of a proper risk management and bid sizing strategy, and there is room to increase positions and loosen stops as you become experienced (not as the price goes up, but as you level up). However, wiggle room aside, the basic layout is something almost literally every pro out there does.

Yet, the above is the exact opposite of what almost everyone does when they start trading or investing in crypto and in general.

What people generally do is commit more money than they can afford to lose to crypto, then quickly buy a small range of crypto assets in a short time frame, and as a result find themselves with a very limited set of options very quickly.

Worse, just as often people will start by practicing risk management and then will start breaking rules when they are overcome by FOMO down the road (which generally occurs when coins are near their local or all time high).

This is very dangerous, because cryptocurrencies can go up hundreds or even thousands of percentage points very quickly and then lose up to 90% of their value nearly as quick.

If you happen to get into a coin high, because say you thought a new trend was emerging where crypto would be good forever and the bubble and bust economy of the past is behind us (this is never the case), you have now set yourself up for hard times.

When you are overexposed in an asset, you aren’t trading or investing, you are gambling. When you gamble in general, things start going wrong (some logistical, some psychological).

When you gamble with more than you can afford to lose, even more things can go wrong.

Further, and speaking honestly, even people who get in early and HODL more than they can afford to lose tend to be consumed by some of the things that can go wrong (like shifting around into alts at the wrong times or using their crypto to open leveraged positions because they are getting bored or greedy).

What Could Go Wrong?

Here is what can go wrong when you overextend generally speaking:

  • You can get emotional and fail to make good choices (whether you are up millions because you got in early, or down tens of thousands because you got in late; once you are overexposed, you are subject to extreme emotion and thus you risk making all sorts of mistakes from freezing up when you should act to selling low in a panic to buying on credit).
  • You necessarily have little or no money to buy dips, corrections, and crashes. If you are all-in crypto, then you necessarily can’t buy the dips.
  • You have no practice at taking money out of the market (to make money trading or investing, you have to sell at some point).
  • You can end up losing 80% or more of your wealth on paper, and then be exposed to pressure to sell (people think they won’t sell when they are down 50%, but no one wants to literally lose all their money; and thus people do sell for a substantial loss in practice, nothing like time and emotion to make you hit that sell or buy button).
  • You can quickly blow up your account by making a few large losing short term bets in a row (especially if you trade using leverage).

Everyone Takes Losses Sometimes; Hence Risk Management

In crypto everyone will take losses here and there, including the pros.

That is the name of the game. The pros know when to take losses, how manage their risk, and generally aim to make more good trades than bad ones (or, to make more good investments than bad ones). Further, pros don’t change their strategy based on emotion, they only respond to market conditions, price action, and fundamentals (so if they are going to go in heavier, it is for a reason).

Amateurs can get lucky by throwing cash at crypto at the right time, but luck can and usually does run out (and often at the worst times; like all time highs or lows).

No one is going to magically be a pro out of the gate, but if you do yourself a favor and manage risk like a pro out of the gate (sticking to it even when the FOMO or fear kicks in), then you’ll avoid all the crazy crypto emotions and their related mistakes like a pro (allowing you to actually stick to your strategy), and thus you’ll give yourself the wiggle room to get crypto trading / investing right before you get REKT.

If 100 people all go all-in on Bitcoin when they hear about it, then everyone who heard about it early has money on paper and everyone who heard about it late has losses. Meanwhile, if they all HODL, and then crypto crashes into the ground, they all have losses. Meanwhile, if they all HODL and it goes up, and then no one sells, they all just have on paper wealth they aren’t doing anything with. In all these cases the effect is essentially the same.

Yet, if those 100 people all built average positions over time, and aim to take profits in some reasonable way, they would roughly be in the same boat (those who came in early would be a little better off; but all would have opportunities to profit and room to make more conservative and educated choices).

If you think two trips to $6k was the worst of what crypto has to offer, you do not know crypto. If you think the next all time high will become the new support, you do not know crypto.

To survive the crypto coaster it is vital to have cash on hand and to be in a position that doesn’t consist of losses that are near impossible to make up.

The Idea That it is Better to Miss out on a 99% Gain Than to Take a 99% Loss of Your Total Bankroll

Consider, if you have $100 and lose 99% of it, you have $1 and need to 99x your $1 to break even (you need a 9900% increase). If you lose 99% of 1% of $100, you have $99.01 and have many ways to not only break even, but to make a profit (you need an increase of roughly 1.01% to break even).

Cryptos can and do go down 80% – 99% all the time (or, frequently enough that you should consider it a possible world).

If you get unlucky and go too heavy into a coin that goes down 99% and you have no exit plan, you have very little opportunities for getting out.

There are countless ways to explain why losing 50% of your money is statistically way worse than gaining 50%, and countless ways to illustrate that it is better to take many smaller bets over time than it is to take a few big bets.

However, others have explained this better than I, and I’m really just relaying their points (as they are true as anyone who stays in the game long enough will learn first hand).

To that point, here is another take on the matter: Risk Management for Trading.

Breaking the rules: Above I presented a conservative investment strategy. Being that conservative isn’t always the right choice for a person or for a given situation. In cases where crypto does a flash crash to a historic low, you’ll probably want to buy a little heavier. If you just took profits at a high and then there is a large correction, reinvesting those profits rather quickly at what you think is the low might make sense. If you see a clear breakout and want to double your bid size or place a few extra bets with tight stops, that can make sense too. The rules aren’t meant to be thrown out the window, but there is a little wiggle room when you are acting with logic and purpose. I know people who are fully in crypto and have made a ton of money. I know people fully in crypto as an investment who swap between the top coins based on data. I can see the logic of jumping ship at what one thinks is the start of a clear downtrend or going in heavy when they think an uptrend is almost certain. Some people do very well throwing risk management out the window or taking big risks, others take some major hits. There is nothing wrong with doing a mix of things and finding out what works best for you and there is no wrong way to invest per-say. However, if you want to avoid gambling (which statically speaking tends not to end well) and want ensure you are in the crypto game for the long term, err toward small positions and set aside dreams of instant lambos for a more sure path to wealth over time.

TIP: It is really hard to get a lambo in a short period of time by being conservative. That said, most people lose money in crypto. To bet that you won’t is gambling. Thus, statistically speaking people are better off not trying to defy the odds.

Author: Thomas DeMichele

Thomas DeMichele has been working in the cryptocurrency information space since 2015 when was created. He has contributed to MakerDAO, Alpha Bot (the number one crypto bot on Discord),...