How to manage risks in trading scientifically?


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Author: Alex Koma

Translation: Sherrie

Risk management is to understand the essence of protection mechanisms

In the final material of the special introduction project, I will introduce to readers the basic principles of risk management when trading cryptocurrencies, and teach how to correctly calculate positions.

Type of risk

There are risks in any financial transaction, and there are many types of risks.


Market risk-the risk of adverse changes in the value of assets;

Credit risk-the risk of the issuer of cryptocurrency going bankrupt or failing to fulfill payment obligations;

Liquidity risk-the risk of not being able to convert all positions into trusted currency (or equivalent) at the best price;

Operational risk-the risk of not being able to perform trading operations or deposit/withdraw assets.

These risks and many other risks affect the operation and stability of financial markets and individual participants. When financial institutions or companies default, financial asset transactions or business activities cause losses, which will have a negative impact on the price of the corresponding assets. This situation usually goes against the interests of stakeholders.

Depending on the complexity and number of such incidents, this may cause the system to collapse and trigger a financial crisis. In 1995, we saw such an example of poor risk management. At that time, Barings, one of the oldest banks, went bankrupt after a trader speculated on Nikkei derivatives and conducted a series of transactions. According to the memoirs of trader Nick Leeson, a high-profile movie “Rogue Trader” was shot in 1999. The bankruptcy of American investment bank Lehman Brothers is often considered the starting point of the global financial crisis at the end of the first decade of this century.

Regarding the serious and far-reaching consequences of ineffective risk management, there are many similar examples. However, let us return to the classification of risks.

Below we will narrowly consider financial risk, that is, investment risk. This risk is the possibility of loss or loss of profit due to financial transactions. It is worth emphasizing that if we cannot influence system risk in any way, investment risk can and should be taken into consideration when dealing with encrypted assets.

In fact, in different economic fields, there are huge differences in the classification, accounting and management of risks. For example, in the field of banking supervision, the most complete regulatory document including risk management is called “Basel III.”

Over time, similar guidelines may be developed for the crypto industry.

Basic principles of investment risk management

The first thing a market participant should do, whether he is investing or speculating, is to allocate such a sum of money so that he can calmly and face the loss. Psychologically speaking, this figure is equivalent to 10% of monthly income. If you intend to continue to professionally engage in this type of activity, then under no circumstances should you use money borrowed from relatives, friends or banks for transactions. In this case, margin trading and securities lending should be extremely cautious, because withdrawing potentially high profits is associated with huge risks.

Here we have drawn a basic and logical principle:


Risk and reward are directly related. In other words, the increased risk should bring a corresponding return, and vice versa. The conclusion drawn from this simple principle is also quite obvious: if we take excessive risks in order to obtain the same or even less profit, then we should abandon this investment.

The next principle is investment diversification, which is very common in risk management. This is about building a balanced investment portfolio. However, before its establishment, diversification should start from reducing operating risks. Allocating available funds among several trading platforms will reduce possible losses due to hacking or closing one of the platforms.

In trading, this is manifested in the correct calculation of open positions, which is also closely related to the general money management mode (fund management). For many novices, an extreme example and a typical mistake is to take 100% capital risk on a transaction/position. Don’t put all your eggs in one basket-this sentence describes the situation perfectly.

In both cases, it comes down to determining the maximum tolerable risk for each operation.

A.Elder’s 2% and 6% rules limit the risk of each session

The standards and basic principles of risk management can be found in many transaction books. Alexander Elder described a fairly popular risk management method in his book. It can and should be applied at the initial stage until its own system for determining transaction risks is formed.

The “shark” in trade and the 2% rule. The above-mentioned error for beginners may lose 100% of their funds. The risk of losing 100% of the funds is variable-the investor’s risk is at the moment of 30-50% or more of the deposit. Elder refers to this situation as the “risk of being eaten by a shark,” because the capital can be returned to zero due to several large losses. To prevent this risk, the size of a position should not exceed 2% of the available funds. This is the “two percent principle.”

The “piranha” deal and the 6% rule. Sometimes, a trader, for one reason or another (more psychologically), cannot prevent a series of unprofitable transactions, which is like a group of predatory piranhas grabbing their prey piece by piece. . If there are many such transactions, then the funds will be in a high-risk area.

The 6% rule limits the maximum share of funds used at the moment of trading. In other words, it sets the maximum allowable risk for each session. If the capital loss exceeds 6%, you need to stop trading for a period of time (Elder recommends 1-2 weeks). First, analyze the situation, and second, avoid psychological errors.

Therefore, Elder recommends that no more than three transactions are opened each time, and each transaction is limited to 2% of the capital. Of course, these rules can be modified over time to suit your trading strategy, changing the percentage and the time spent on analysis, but it is recommended to keep the basic concepts in their original form.

Correct position calculation

It is necessary to formulate a rule to calculate everything as a percentage. Risk can be described as the possibility of adverse outcomes. In addition, risk is understood as the level of possible economic loss. Therefore, risk is a two-dimensional quantity that represents the probability and quantity of loss (from total capital), and all these values ​​are expressed in percentages.

When calculating, it is very important to consider the various costs of encryption exchange. They can be:

Transfer, deposit and withdrawal of funds;

Open a position (and close another position);

Use of leverage, etc.

Leverage ratio and its impact on risk

Cryptocurrency exchanges can be roughly divided into the following types:


The important point here is that leverage increases the size of positions, but also increases the same amount of risk. For example, under the leverage of 100, moving 1% from the opening price to the opposite direction will result in a 100% loss and a margin call (in fact, due to commissions and trading mechanisms, even earlier).

Position control

In order to manage positions, you need to wait for the order using stop loss (SL) and take profit (TP). Let’s introduce this value:

如何科学地在交易中管理风险? among them:

C —— profit and loss ratio;

A —— Profit when the TP instruction is triggered;

B-Lost when the SL order is triggered.

In the literature about trading, it is often recommended to use trading strategies and entry points, the calculated value of which is C from 2 to 3. In other words, the potential profit from the transaction should be several times the possible loss.

Some traders do not use SL in trading and tend to “stand by”. This complicates risk control (the decline may continue). This is especially true in margin trading.

We strongly encourage all novices to use SL in leveraged trading.

The following table shows the percentage of capital gains required to maintain a balance of payments under different loss amounts:

如何科学地在交易中管理风险? From the data in the table, it can be seen that position size management plays a key role. The more traders lose, the harder it is to recover their original trading funds.

For example, a deposit of $1,000 becomes $100 after a series of losses. Now, in order to recover the initial funds, the trader needs to increase the amount of $100 by 900%.

Without proper risk management, stock exchange transactions can become casino games.

Use Kelly formula to calculate positions

Many investors use the Kelly formula to manage risk. Its function is to determine the maximum allowable percentage of capital available for trading.

The formula for calculating capital proportion is as follows:

如何科学地在交易中管理风险? among them:

x ——Amount of operation/transaction;

K-is the amount of available capital.

The Kelly formula defines the limit value of f:

如何科学地在交易中管理风险? among them:

P —— is the probability of a positive outcome of the trading strategy;

A ——Profit when the TP instruction is triggered;

B —— Loss when the SL order is triggered;

g-the leverage used (equal to 1, if no leverage is used).

It is not recommended to use the maximum fmax value to calculate the square leverage formula.

The best range to reduce the assessment risk:

如何科学地在交易中管理风险? At this stage, there is an additional risk associated with incorrect definition of probability.

Probability of use

There are several different ways to determine the probability of a positive investment outcome:

If the prediction source is external, the average percentage of successful signals can be used as a reference point. However, it should be remembered that, for example, no-array/chat instant messengers (mainly telegrams) may distort real statistics;

If a trader/investor independently applies a trading strategy, keeps trading records, and has reliable and complete statistics (or has the ability to test his strategy in history), then:

如何科学地在交易中管理风险? among them:

p ——Possibility of a positive result of the trading strategy / conversion of active trading;

M-the number of profitable industries;

N ——The total number of transactions of the strategy.

You need to understand that in any case, the data from the transaction log (report) will not give a static result-there will always be errors and scattered values. When processing historical data, there is always the risk of changes in market conditions, which will lead to a decline in the effectiveness of future strategies.

in conclusion

As we said at the beginning of the special project, any financial transaction is risky. The main task of investors is not to give up the risk altogether, but to choose a solution-to what extent is it reasonable to take on this risk.

In any type of investment, it is necessary to be able to identify risks in advance and correctly. In other words, you should understand what the potential profit we expect and what the loss we are prepared to accept. In addition, if there is no systematic trading, none of the above suggestions will give a result. Systematic trading means accounting, calculating and analyzing all open positions.

A truly successful trader is not someone who has made millions, but someone who does not lose or lose in the market.

Disclaimer: does not endorse any content or product on this page. While we aim at providing you all important information that we could obtain, readers should do their own research before taking any actions related to the company and carry full responsibility for their decisions, nor can this article be considered as investment advice or recommendations. Every investment and trading move involves risk, you should conduct your own research when making a decision.