Understanding Risk Management in Algorithmic Trading and Financials Markets

Thu Apr 13 2023

Having a solid risk management approach for your algorithmic trading strategy is absolutely crucial. Here are some of the best practices that you can start applying in your cryptocurrency trading today.

Risk management is a crucial practice in financial markets and business administration. It involves assessing and reacting to risks that are inherent in all kinds of businesses. In essence, risk management is all about identifying and mitigating potential risks that may cause negative effects. This couldn’t be more important in algorithmic trading, where a strategy might be able to perform exponentially more actions than manually trading the market would. In this article we’ll be running through risk management best practices and how to apply those in you algorithmic crypto trading strategy on Æsir.

The Risk Management Process

In both algorithmic and manual trading, the risk management process involves five steps: setting objectives, identifying risks, risk assessment, defining responses, and monitoring. The first step is to define the main goals, which are often related to your risk tolerance. The second step involves detecting and defining potential risks. After identifying the risks, the next step is to evaluate their expected frequency and severity. The fourth step consists of defining responses for each type of risk according to their level of importance. Finally, the last step is to monitor the overall efficiency of the risk management strategy in response to potential events.

Managing Financial Risks

In financial markets and cryptocurrency trading especially, having a proper risk management strategy is crucial to success. A robust trading strategy should provide a clear set of possible actions, meaning that traders can be more prepared to deal with all sorts of situations. There are several ways of managing risks, including:

Setting a Stop-Loss

Stop-loss orders allow traders to limit losses when a trade goes wrong. Ideally, stop-loss prices should be defined before entering a position, and the orders should be set as soon as the trade is open. In fact, you won’t be be able to start an algorithmic trading strategy on Æsir without a stop loss in place. It’s that important.

Setting a Take-Profit

Take-profit ensures that traders lock in profits when a trade goes well. Ideally, take-profit prices should also be defined before entering a position. This happens automatically on Æsir, so all you need to worry about is setting this value to a level you’re satisfied with.

Level up with a Trailing Stop Loss

If you want to ensure that you make the most out of your trades when they’re going the right way, you might want to consider using a Trailing Stop Loss and Trailing Take Profit. These values act as a pincer that surrounds the current price of the asset you’re trading, and they will move up with the price as the price increases. Trades will only close once the momentum ends and the price starts to fall, allowing you to maximise your gains from each order. You can easily set this option in Æsir.

Hedging

Hedging is another strategy traders and investors use to mitigate financial risk. It consists of taking two positions that offset each other. You can hedge one trade by making an opposing trade of similar or equal size. You could also hedge by placing orders on assets or pairs that have a negative correlation for instance: ETH/BTC vs BTC/ETH. These assets will always negatively correlate.

Diversification

A well-diversified portfolio offers more protection against massive losses compared to a portfolio made up of only one single asset. In theory, if you hold a crypto asset in a diversified portfolio, the maximum damage you would receive if its price tumbles is a percentage of your portfolio. This also applies in algorithmic trading.

Risk-Reward Ratio

The risk-reward ratio calculates the risk that a trader will be taking relative to the potential reward. To calculate the risk-reward ratio of a trade you’re considering, simply divide the potential loss by the potential profit. A common pattern for many trades is a ratio of 3:1 that can be set up in place using Take Profit and Stop Loss. Having your Take profit be x3 higher than your Stop Loss means that you only need one good trade to offset 3 bad ones.

1% Trading Rule

The 1% trading rule (or 1% risk rule) is a method traders use to limit their losses to a maximum of 1% of their trading capital per trade. This means they can either trade with 1% of their portfolio per trade or with a bigger order with a stop-loss equal to 1% of their portfolio value. The 1% trading rule is commonly used by day traders but can also be adopted by swing traders.

Conclusion

In conclusion, knowing how to properly risk manage, and when to exit a trade plays an essential role in algorithmic cryptocurrency trading. It involves identifying, assessing, and mitigating potential risks that may cause negative effects. While financial risks can’t be completely avoided, having a proper risk management strategy can help traders and investors handle risks in the most efficient way possible. The best way to learn is by doing, set up an account on our algorithmic cryptocurrency trading platform Æsir, and try out different risk management strategies in paper trading mode. That way you can see how your strategies react to the market without risking real funds!