In today’s digital age, keeping your hard-earned money safe is an essential life skill. There are some basic safety principles that you are probably already familiar with and apply in traditional finance.
Would you, for example, give your bank login information to just anyone? You’re always careful not to conduct business over public WiFi, right?
You literally don’t put all your eggs in one basket by investing all your money into a single asset; you don’t share your credit or debit card information in public places, and so on.
These are excellent TradFi safety tips, but now, let’s talk crypto. Crypto is a whole new ballgame with its own set of rules, and one of the top skills you need to master to keep your cryptoassets safe is risk management.
Whether you’re buying tokens, playing the long game with a “HODL” strategy, riding the waves of market ups and downs, or going after those high-reward opportunities through yield farming, you’ve got to ask yourself: How can I keep my investments safe and my profits locked in?
Sure, crypto prices can swing wilder than a roller coaster, but that’s not the only thing to worry about. Even if you’re a trading pro who can ride those price changes, there’s still a chance you could end up losing big.
This is why understanding and managing risks in crypto is indispensable. It’s like learning the rules of a new game before you start playing.
In this article, we’re your guides to crypto risk management, and we’ll break it all down so you can make smart moves and protect what’s yours.
First things first, let’s outline the different types of risks you’ll likely bump into in the cryptoverse.
Types of Risk in Crypto
Volatility Risk
When trading or investing in cryptocurrencies, things can get wild. Prices can swing up and down like a rollercoaster on steroids. Imagine your investment dropping by half in just six months – that’s the kind of ride we’re talking about. In extreme cases, you could even lose everything.
An investor or trader must be ready for sudden twists and turns. Knowing the likelihood of this happening can help navigate this rollercoaster ride.
Regulatory Risk
Crypto regulations today are a bit like a patchwork quilt – different pieces, different patterns. The regulations that govern the crypto world vary a lot depending on where you are. This can be tricky because you might not be sure if your activities are crossing any lines. It’s like driving with different speed limits in every town – you need to know the rules to avoid getting a ticket.
To play it safe, make sure your crypto moves match the laws of the place you’re in.
Cybersecurity Risk
Cybersecurity risks take the front seat when we talk about internet technology. Both decentralized and centralized crypto protocols can fall victim to hacks, putting users in the unfortunate position of potentially losing their hard-earned funds.
In 2022 alone, a whopping $3 billion was lost to crypto hacks, with investors and crypto traders the hardest hit. So, if you’re thinking about dipping your toes into the crypto waters, it’s imperative to have your radar tuned to these market risks.
Technology Risk
The concept of cryptocurrencies is still relatively nascent, and it’s not without its flaws. Just like with any new technology, there’s always a chance that things might not go as planned. In fact, every technological advancement carries some level of risk—whether we’re talking about airplanes, manufacturing machines, or fintech innovations.
For instance, certain yield farming protocols require plugging into other protocols to optimize returns. This means these protocols need to link their smart contracts together for interoperability, introducing significant risk. Simply put, if there’s a vulnerability in the smart contract of one protocol, it could jeopardize the security of all the connected protocols.
Liquidity Risk
DeFi is an important aspect of cryptocurrency investing. It represents a financial landscape that does not require a central party to initiate or complete a financial transaction. Instead, it’s the market players who keep the money flowing smoothly.
But here’s the thing: sometimes, this flow of money can slow down, and that’s when traders end up buying higher or selling lower than they should. These liquidity hiccups can mean losses for everyone involved.
People Risk
The human factor risk in crypto gets less spotlighted but is worth paying attention to. While we’ve discussed risks arising from factors beyond our control, this one is slightly different. It results from people’s decisions and adds an interesting layer to the overall risk picture.
Decentralization is one of the core tenets of crypto, so who’s behind a project often doesn’t matter. Sometimes, projects are led by mystery CEOs or teams, following in the footsteps of Bitcoin’s creator, Satoshi Nakamoto, about whom very little is known.
However, knowing the people behind a project can provide extra credibility as the industry has become saturated with millions of actors, not all with good intentions.
Although knowing a crypto company’s CEO is no guarantee against chronic mismanagement under their watch. Mega companies like Celsius and FTX had well-known CEOs yet still ended up with major problems that cost customers a lot of money. This shows that even with popular leaders, risks tied to human decisions can’t be underestimated.
How to Manage Risk in Crypto
Even though it may seem like an adventure with endless risks, the crypto market is not necessarily off-limits. In fact, many individuals have made significant profits from cryptocurrencies, making it a viable option for generating passive income.
To stay safe while investing in crypto, here are some suggestions on how you can approach risk in the crypto market.
1. Risk what you can afford to lose:
Do not invest in crypto with a get-rich-quick mentality.
The best way to stay protected in case the most unlikely scenario occurs would be to only invest funds you’re willing to lose.
By allocating only a portion of your net worth or earnings to crypto, you’re more likely to be better off even in undesirable scenarios.
2. Always take profit:
You can only earn your reward in crypto by taking a profit.
Crypto traders and investors are often caught in the excitement of positive PnLs and unrealized gains, forgetting the true nature of the market: its volatility.
The crypto market can yield quick gains and high returns, but it also can cause rapid, significant losses. Once you come to terms with this reality, you’ll realize the importance of taking profits as a trader, investor, or yield farmer.
A double of the market value of your initial investment is already a decent enough opportunity to take profit. It’s perfectly okay to keep riding the wave of profitable trades – after all, we’re all aiming to make the most of our investments. But the smart move is to steadily lock in profits from the market to place yourself in a better position to weather any unexpected market fluctuations.
The best time to take profit is when it is right there for the taking. Keep in mind that there’s no surefire way to predict the market’s peak or bottom.
3. Do not borrow to invest in crypto:
Investing in cryptocurrency might look like a promising money-making opportunity. But, if you’re new to this market, it’s crucial not to let the fear of missing out (FOMO) push you into making hasty investment choices.
Avoid going to extremes, like borrowing money to invest, even if the idea sounds tempting. Such decisions can lead to unexpected and undesirable outcomes. Stick to using your own funds, money that’s truly yours and that you can handle losing, when you’re venturing into cryptocurrency investments.
4. Check that the smart contract you’re interacting with is secure:
DeFi, short for Decentralized Finance, operates using exchange and lending systems like Pancakeswap and Aave. These platforms run on smart contracts, which are computer-programmed codes that allow them to work without a central authority. But, because smart contracts are essentially code, they can have vulnerabilities.
To spot these potential weak spots, developers closely examine the smart contract code of DeFi protocols. Even if you’re not a developer yourself, you can still find out if a DeFi platform’s smart contract has been reviewed by experts and if the reviewing company is reputable.
These reviews, called audits, are crucial for finding and fixing vulnerabilities in a platform’s smart contract. Before a DeFi platform is open for everyone to use, it has to go through one or more of these audits.
Although audits can’t promise a smart contract is completely bulletproof, they are an important step in making sure you’re putting your money into platforms that care about protecting your assets.
5. Diversify your crypto investments:
Just like you wouldn’t want to put all your eggs in one basket, it’s a good idea not to invest all your money in just one type of cryptocurrency.
If you’re thinking about putting a significant chunk of your earnings or savings into the market, it’s smart to spread your money out across different crypto assets.
Diversifying your investments can be as simple as having some Bitcoin (BTC) along with stablecoins. This way, if BTC’s price goes down, the stablecoin tied to the US dollar or any other stable fiat currencies can help balance out some of those losses.
It’s also a good idea to consider holding a variety of stablecoins to avoid relying too much on just one. For instance, in 2022, people who invested in TerraUSD, a stablecoin designed to always be $1 per unit, ended up losing all their money when its value suddenly dropped to zero.
And don’t forget about diversifying across different crypto ecosystems. Let’s say you’re investing in Solana’s SOL and other crypto projects connected to the Solana ecosystem. It’s not a great idea to have all your investments tied up in just that one place, because then your success is riding entirely on how well that specific ecosystem does.
6. Have an exit plan:
It’s important to acknowledge that not every investment, whether in crypto or any other field, will turn out to be a winner. That’s why having a clear exit plan is crucial. This plan helps you avoid making emotional decisions when faced with a bad trade.
To create your exit plan, start by deciding how much potential loss (drawdown) you’re comfortable with in a trade. Also, learn to spot general signs that indicate a trade is going sour, distinct from the usual ups and downs of the crypto market. Remember, just because you’ve only invested what you can afford to lose doesn’t mean you have to accept total losses.
If you start feeling uneasy about an investment due to specific events, take a moment to evaluate if it meets your criteria for a bad trade. If it does, consider cutting your losses.
For instance, let’s say you invest in a new project with high hopes for its success. But if the project experiences internal conflicts among its founders and the CEO is revealed as a fraud, the token’s value will likely drop as other investors lose confidence.
In such a situation, it’s wise to follow suit and exit the trade. Holding onto hope for a recovery or avoiding loss recognition can backfire, potentially leaving you with nothing to show for that trade.
It’s worth noting that this article discusses potential risks in the crypto world and offers ways to protect yourself against them. However, there’s also a concept called “known unknowns” – situations where you’re aware something might occur, but you can’t predict how it will unfold.
In the context of managing crypto risks, “known unknowns” refer to security risks that haven’t surfaced yet, like a new type of vulnerability in smart contracts that hasn’t been discovered.
Additionally, there are unforeseeable events, often known as Black Swan events, that catch everyone off guard. That’s why it’s advised not to invest all your funds in cryptocurrency. Stay informed about your investments and stay updated on market happenings. Your utmost priority should be ensuring the security of your funds.
In Conclusion,
- The crypto market is known for its high volatility, which can make it a bit risky. But don’t let that scare you off. It’s normal for investments to come with risks; what really matters is how you manage them.
- To navigate this, start by understanding these risks. This way, you can quickly recognize them and take action to prevent or solve issues.
- While it’s smart to know about the various risks in the market, you can’t predict every single one. Some risks are easier to prepare for than others.
- So, the best tip is to only invest money that you can afford to lose. That way, if something unexpected happens, you won’t lose everything you’ve put into crypto. This cautious approach protects you from the worst-case scenario and keeps your wealth from being wiped out by your crypto investments.
Disclaimer: This article is intended solely for informational purposes and should not be considered trading or investment advice. Nothing herein should be construed as financial, legal, or tax advice. Trading or investing in cryptocurrencies carries a considerable risk of financial loss. Always conduct due diligence.
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