Playing With Fire: 5 Crypto Risk Management Strategies You Need to Know
Don't be a hero. Follow these five crypto risk management strategies.
Updated Feb 7, 2023
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Cryptocurrencies are the most popular speculative asset class today, but they're also some of the riskiest—remember, with great returns comes great responsibility. Crypto risk management is essential for keeping your portfolio up, especially in a bear market.
Although some investors in the crypto space had to learn these lessons the hard way, you can skip a few grades in the school of hard knocks by following these risk management crypto trading tips.
Crypto Risk Management
Crypto Risk Management
Leveraged trading is a great way to go long or short on a particular crypto, but it also exposes investors to much greater risk when compared to just holding the crypto itself.
There's no definitive way to eliminate or even greatly reduce crypto investment risk. Still, there are things you can take into consideration that can help you make smarter decisions as an investor.
Here are five things you can do to decrease risk and make your crypto portfolio more successful in the long run, regardless of market conditions.
Don't stake too much
The introduction of proof of stake (PoS) consensus to blockchain technology has brought new passive income opportunities along with it. Staking is a mechanism where investors lock their crypto assets to help secure networks while earning in-kind rewards.
The best example of this is the Ethereum merge because it enabled ETH holders to stake their coins on the Beacon Chain and earn passive yield—the catch is that staked ETH and rewards earned from it are locked until after Ethereum's proof of stake upgrade.
While not all staking contracts are indefinite, delegating your assets to a validator on a PoS blockchain is a long-term yield strategy since unstaking (sometimes called unbonding) isn't always immediate and can take several hours, days, or even weeks.
One solution to this is liquid staking tokens like stETH that allow you to trade staked crypto assets without having to withdraw them, but even these are at risk of depegging based on liquidity constraints and the performance of the underlying asset.
Since January 1, 2023, Lido has offered between 4.8% and 6.4% APR on staked ETH.
Source: dune analytics
So, no matter how great the staking rewards are, it's safer to stake less rather than more. Staking can be used strategically to earn interest on idle assets, but it's not always possible to enter and exit staking positions quickly.
Additionally, staking rewards are locked for the duration of your stake and the rate earned can change as more investors stake their crypto assets, which means crypto staking profits aren't the most reliable.
Fear isn't a factor
One of the most impactful metrics on crypto assets are market trends and sentiments like fear. Most seasoned investors are familiar with the Bitcoin fear and greed index, but measuring sentiment isn't an exact science and it shouldn't be the end-all and be-all of crypto investing. In other words, FOMO (fear of missing out) shouldn't prevent you from selling an asset and FUD (fear, uncertainty, and doubt) shouldn't keep you from buying an asset, either.
There's no guarantee that past performance will dictate future performance or that your asset will even keep going up, but you have hopium—a portmanteau of 'hope' and 'opium'—that the price will rise despite no fundamental indicators or rational explanations pointing to it.
Conversely, a sentiment of doubt could steer you to sell an asset that would have appreciated if you kept holding it. Despite the critical opinions of your investing peers, you must develop strong judgment and make investment decisions backed by strong evidence.
While your instincts can go a long way and you can be influenced as an investor by the narratives you consume, the best approach is to rely on facts to convince yourself of your choices rather than letting emotions like fear and hope dictate your actions.
Hold onto stablecoins
The importance of holding stable assets can't be overstated in the cryptocurrency market. Stablecoins are a crucial must-hold for investors because they mirror traditional assets, but which stablecoins you hold matters, too.
The safest stablecoins include centralized ones like USDT or USDC and overcollateralized financial instruments like DAI—which have all maintained a reliable peg to the U.S. dollar for years. Algorithmic stablecoins are on the opposite end of the spectrum since there aren't any assets backing them, which makes them more likely to de-peg significantly from their target value.
Despite overwhelming confidence, even among institutional investors, that stablecoins are the best hedge against cryptocurrency volatility, room for doubt has slowly crept in. First, the world's largest stablecoin issuer Tether has been repeatedly criticized for lacking transparency in financial reports since launching USDT in 2017.
More recently, the collapse of Terra's algorithmic stablecoin UST severely shook investor confidence in stablecoins within the crypto market and traditional financial markets.
Stablecoins are unique assets because they combine the utility of a blockchain token with the stability of fiat currencies, thus allowing investors to enter and exit crypto positions safely and effectively.
However, being exposed to just one stablecoin is riskier than having allocations in multiple stablecoins that are each backed or issued differently. That's why investors should hold a diverse risk-weighted portfolio of stablecoins to either invest or deploy into yield farming strategies.
Practice self custody
Investors should have a balanced distribution of assets between crypto exchanges and external wallets. Different types of crypto wallets each have a unique risk associated with them, so assets on custodial wallets are exposed to different threats than those held on DeFi wallets. Hardware wallets like Trezor or Ledger are the most secure, but they aren't as good for cryptocurrency trading or selling crypto for fiat currency as exchanges like Gemini or Coinbase are.
Accounts on centralized crypto exchanges are custodial, which means the private keys to your crypto wallets are in the hands of the exchange. This is alright for most investors, but those who want less exposure to the exchange can take more responsibility for their assets by depositing them into a crypto wallet which they hold the keys for.
These days, you can connect to DeFi applications like the NFT marketplace Opensea or decentralized exchanges like Uniswap right from the Coinbase app, so whether or not you want to keep your assets on an exchange is ultimately up to you.
The main reason a crypto investor or trader would practice self-custody is to manage exposure to risk factors across all platforms. For instance, if your account on an exchange gets hacked or your funds get stolen from the platform, there's no way to recoup your losses since exchanges aren't insured the same way traditional investment accounts are.
However, non-custodial wallets can also be hacked, so the best way to manage risk is to spread your assets across several exchanges and crypto wallets. Having your crypto stored on different types of crypto wallets is the best way to ensure security and minimize losses due to dumb mistakes.
A note on taxes
One important aspect of self-custody are proper tax practices. While managing risks can help reduce the impact of volatility on your portfolio, tax planning can help minimize your legal compliance risks. Learn how alternative investments are taxed before you dive headfirst into crypto trading.
Be cautious with leverage
Crypto risk management is most difficult for traders engaged in risky strategies like margin or leveraged trading. Using leverage is a great way to go long or short on a particular asset, but it also exposes investors to much greater risk when compared to just holding the asset itself. This is because leveraging involves using your investment as collateral for a loan to buy more assets.
Using leverage is one of the riskiest decisions you can make as an investor since it's simply an all-or-nothing gamble on the price action of an asset.
If you go long on a crypto investment and it drops below the margin price, then you could get called or lose your entire investment to liquidations. If you go short on a crypto asset and its price goes up, then you could get margin called or be stuck with loans you can't pay back.
These are both worst-case margin trading scenarios, but they're real possibilities for how a leveraged position could end up. While it makes sense to stay away from margin trading altogether, the risks of doing so can be greatly reduced by closely attending to your positions and not taking on too much leverage.
Keeping the margin price far away from the market price may reduce the risk of a margin call, but remember that even the best risk management strategy can't save you from the perils of highly volatile crypto markets.