How to manage risks in cryptocurrency investment

Investors will definitely see risks in a swinging market. Think back to the year 2022, when most asset classes saw sharp declines. For instance, the Shanghai Composite Index declined by 15.13%, the Hang Seng TECH Index dropped by 27.19%, the Nasdaq Index fell by 33.03%, and the Russia Trading System (RTS) Index slumped by 41.29%. The total crypto market capitalization also fell from $2,246 billion to $796.1 billion, witnessing a 64.55% drop. This prompts investors to the familiar principle: one should always be wary of potential risks when taking action on any investment. But how can we avoid risks and reduce losses?

The answer is risk management, which can effectively help investors reduce losses and ensure the security of their principal while protecting their profits. Before conducting risk management, it is necessary to clearly understand whether the risk is controllable, what risks the crypto market may face, and how to carry out effective risk management.

Types of Crypto Risks

It is imperative to have a holistic view of risks. As a novel investment option, the risks in the cryptocurrency market present unique features. Only by understanding these risks comprehensively can we make successful investments in the future. Let’s dive deep into the common risks of the crypto market and learn how to carry out effective risk management.

Risks from the Project Team

As the party that launched a blockchain, the project team exerts a direct impact on the development of the project. At present, the regulatory system for blockchain projects is not complete. Some unscrupulous projects do nothing after receiving investment, and even try to abscond with investors’ funds. This behavior is described as a “rug pull’. Generally, a rug pull is implemented by stealing liquidity, setting malicious codes and loopholes, and selling or dumping assets, with a view to accelerating the depreciation of investors’ holdings.

In December 2021, the popular on-chain game “BNB Heroes” crashed. The liquidity of the BNBH/WBNB liquidity pool slumped from December 5, 2021, to December 7, 2021. The price fell from $3.8 to $0.19, seeing a drop of more than 90%.

(Source: avedex, https://avedex.cc/home)

Investors should be particularly cautious before taking action. First, it is important to verify the identities of the project team members. It is advised to research team members’ experiences in this industry and their reputation. Second, investors should know whether the project is endorsed by reliable investment institutions. If yes, the potential risks reduce. Finally, choose a reputable exchange, such as Gate.io, which conducts thorough reviews before listing projects.

Token Unlocking Risk

Typically, token issuers disclose information about the total supply, distribution, and release mechanism. Some tokens unlock a small amount in the early stage while the rest are in the middle and late stages, making it easier to control the trading market and drive up the price to attract users in the initial stage. While in the middle and late stages, the price may decline for a long time as a large number of tokens unlock.

Therefore, investors need to clearly understand the token issuance mechanism and unlocking plan, and be cautious about projects that are intended to unlock in large quantities in the early and middle stages. Token unlocking details can be found on the official website of the project or on third-party platforms, such as TokenUnlocks.

Project Mechanism Risk

The sudden drop or rise of a token is directly related to the mechanism of the project.

Among them, a typical example is LUNA (now renamed LUNC), an algorithmic stablecoin. The project is to issue the stablecoin UST, which is pegged to the value of the US dollar through algorithms. Specifically, the algorithmic mechanism is as follows: if the price of UST is greater than $1, users can use $1 worth of LUNA to mint 1 UST, and then destroy that LUNA.

If the price of UST is lower than $1, users can destroy 1 UST and mint LUNA which is worth $1 worth. The two-way exchange between the two currencies ensures that UST is always stabilized at $1. If there is a strong demand for UST, LUNA will be destroyed in large quantities, driving up the price of LUNA. On the contrary, if there is a large selling pressure on UST, LUNA will be issued additionally, driving LUNA to drop. In early May, a whale address showed up and the project team announced to lower the interest rate of UST. As a result, a large amount of UST was sold, causing UST to lose its peg and drop below $1. Then, LUNA was issued additionally in large quantities. In the end, LUNA fell from around $70 to below 0.0001 during the week from May 8 to May 14, 2022.

(Source: https://coinmarketcap.com/)

The project mechanism determines that the prerequisite for LUNA to rise is that UST stabilizes at around $1. Once UST is depegged heavily, LUNA will be issued without limit. Only by developing a good understanding of the mechanism can investors prevent themselves from going bottom fishing blindly when LUNA is still on the decline. Some on-chain arbitrageurs could even seize this opportunity to make a big fat profit.

Therefore, it is essential to understand, before making an investment, the mechanism of a project, the role of its token in the ecosystem, and the operating mechanisms related to the token (if any).

Liquidity Risk

Liquidity risk refers to the difficulty of buying and selling tokens within the specified time and price range. In a market with strong liquidity, transactions are easier to be filled and have lower slippage. In a market with insufficient liquidity, the buying and selling behaviors will cause heavier price fluctuations and the prices are prone to be manipulated, causing the market to either skyrocket or plummet. Assuming that the price of a token is 10 USDT: in a market with sufficient liquidity, orders placed at around 10 USDT will be easier to be filled; if the liquidity is insufficient, only part (or none) of the order will be filled with this price. Therefore, remember to place orders at a lower price, say 9.9, 9.8, or lower, to increase the likelihood of the trade being executed. In this scenario, the price is prone to go down when there are large sale orders.

Alameda Research is one of the largest market makers in the cryptocurrency space, providing billions of dollars worth of liquidity for a variety of tokens. But the implosion of FTX has triggered a liquidity risk for these tokens.

To avoid such risks, investors should pay particular attention to market news.

Hacking Risk

Blockchain projects feature openness and transparency. As public chain projects are secured by miners and nodes, these projects are less susceptible to attacks; however, cross-chain bridge projects may link the secure platforms to those that are less secure; emerging applications such as DAO and GameFi are still in development and are more vulnerable to hacks. In 2022, the total amount of cryptocurrency being hacked was about $3.7 billion, of which cross-chain bridges lost more than one-third of the total amount.

Hence, never invest too much in cross-chain bridges and emerging applications.

Policy Risk

Policy risks can arise unexpectedly and without warning. As more regulators intervene, the industry is driven to develop a more compliant path. In this case, projects that go against the regulations should reduce their investment. In 2022, Tornado suffered the most from regulatory policies. In August 2022, the Office of Foreign Assets Control (OFAC) of the U.S. Department of The Treasury sanctioned Tornado Cash, prohibiting U.S. entities and individuals from using Tornado Cash services and requiring that ETH addresses related to Tornado Cash be sanctioned. As a financial institution regulated by the Bank Secrecy Act (BSA), Circle, together with its partner Coinbase, has restricted the flow of USDC funds in these sanctioned addresses. This was the first time that smart contracts on the chain were directly sanctioned by OFAC. According to the Treasury Department, Tornado Cash has facilitated over $7 billion in money laundering since its launch in 2019.

The price for the Tornado Cash cryptocurrency TORN fell by 70% within one week in mid-August.

(Source: https://www.gate.io/）

Risk Management Principles

Manage your emotions appropriately while assessing risks

Risks are seen everywhere, but fortunately, most risks are controllable if fundamental risk management measures are applied. In the financial markets, opportunities are always accompanied by risks. In 2022, the crypto market ushered in many excellent investment opportunities. Some investors seized the opportunity to obtain good returns. We must have an in-depth understanding of risks and learn to control the greed and fear emotions in human nature. Buy low and sell high, which is the law we should always follow. When the market is booming, we should pay more attention to potential risks.

Diversify your portfolio

Putting all your eggs in one basket increases your investment risk. Among a variety of investment options such as bank deposits, bonds, stocks, and cryptocurrencies, investors can combine capital-guaranteed investment with risky investment to guarantee the principal while making profits. Diversifying investment categories to reduce the overall risks. If all funds are invested in a single asset, whether it is cryptocurrency or stock, the risk increases.

Measure your risk tolerance before investing

Although every investor hopes to obtain good returns, even professional investors could not get a 100% success rate. Therefore, it is important to know how much loss you can bear. If the loss would affect your normal life, it would not be a wise choice.

Focus on sectors you are familiar with. Avoid too diversified investments.

After 14 years of development, the cryptocurrency market has incubated various different sectors, giving birth to thousands of blockchain projects. Investors should pay close attention to project information in a timely manner. However, for investors who are not professional investors, it is not possible to keep up with the latest news of all projects. Therefore, it is suggested to choose 2-3 major sectors to invest in, thereby making more profitable investment decisions.

Risk Management Methods

Enhance your acuteness to recognize potential risks

From the part above, we have a better knowledge of common risks in the crypto market. It is important to research these risks and projects before making an investment. Do not make any investment without a clear understanding of potential risks. Discover the risks based on fundamental and technical analysis and avoid investing in projects with uncontrollable risks. To dive deeper into what technical and fundamental analysis of cryptocurrencies are, please refer to articles on Gate Learn.

Develop good investment habits

To be a successful investor, one must have the courage to invest, especially in a depressing market. While in a prosperous market, it is important to not be too greedy. In most cases, we keep these principles clearly in our minds but find it difficult to follow them strictly in real-world practices. To improve this situation, we need to develop good investment habits and trading discipline. For example, formulate an investment plan of your own, set a stop-loss or take-profit price, learn to predict and penetrate new possibilities in the market, etc. Be sure to implement the plans once you made them and try to minimize the negative impact brought by your emotions.

To keep good investment habits, it is also critical to:

A. Make investment decisions when you are sober-minded;

B. Review your previous investment decisions regularly to optimize your investment portfolio;

C. Adjust your investment decisions if you have encountered obstacles several times.

Set a stop-loss limit

Whatever the risk is, one certain result comes in the end: to make a profit or suffer a loss. Risks can be effectively controlled by setting a stop-loss price. For example, if you accept a loss of less than 5% of the total assets, you can set a 5% stop-loss price when placing an order with all of your funds, or a 10% stop-loss price when placing an order with 50% of your funds.

Adjusting the investment portfolio is another way to control the stop-loss. It would be more appropriate to allocate your assets based on your risk factor. Among a wide variety of cryptocurrencies, BTC/ETH has the lowest risk, mainstream currencies (currencies launched by leading projects in each sector) come next, and altcoins face the highest risk. According to the asset classes investors have in their portfolios, investors can be grouped into four types: conservative investors invest in 80-90% BTC/ETH, 5-15% mainstream currencies, and less than 5% altcoins; stable investors invest in 60-80% BTC/ETH, 10-30% mainstream currencies, and 5-10% altcoins; radical investor invest in 40-70% BTC/ETH, 20-40% mainstream currencies, and 10-20% altcoins; risk-taking investors invest in 0-40% BTC/ETH, 40-60% mainstream currencies, and 20-40% altcoins. There are many other standards that define different types of investors. We are only taking one of them as an example to exemplify how to control the risks by setting appropriate investment portfolios.

Invest in different stages to increase the winning chance

We strive to be objective when making investment decisions on the basis of market research. However, the success of your investment ultimately depends on market conditions. Investing in different stages is a wise option to reduce risks. Specifically, you can invest small amounts of funds and gradually increase your positions if the market trend proves promising. If not, whether you choose to wait for a market reversal or just stop loss and exit, your losses will reduce.

Conclusion

Effective risk management is crucial for securing profits in investments and safeguarding the principal. As people view the impact of risks differently, they take different risk management measures in practice. Despite that, all these measures are taken on the basis of a comprehensive assessment of the risks, the allocation of investment assets, the setting of stop-loss limits, the choosing of underlying assets, the control of investors’ emotions, etc. Risk management is vital in both the initiation and advancement of your investment journey. Only by understanding the market and the risks correctly can you make profitable investments in the future.