Money management is a crucial part of cryptocurrency trading that will play a large part in determining whether or not your overall strategy is a success. When executed properly, it can not only help you maximize your profits but also minimize your risks and protect your capital. It will also help you avoid sticky financial situations due to bad trading habits.
In this AAG Academy guide, we’ll explain what money management is, cover the benefits, risks, and rewards, and look at a number of popular money management strategies to help you become a better cryptocurrency trader.
What is money management in cryptocurrency trading?
If you’re new to cryptocurrency trading, it can be easy to simply dump any spare cash you have into coins and tokens that are popular or garnering a lot of attention. The problem with this is that it’s not a particularly considered strategy, and it’s likely to lose you money more often than it makes you money. What’s more, you could end up losing more than you can afford to lose.
One of the reasons why this is so common, particularly among newer investors, is that the psychological factor plays a major role in trading. When we allow it to be the only factor, trading becomes more like gambling and our decisions become too impacted by our emotions. We can chase “wins,” and make bad moves in an effort to recoup losses we can’t afford to take.
Money management is the solution to this problem. It essentially consists of implementing techniques and strategies to limit your risks and maximize your rewards. It won’t protect you from losses altogether, but when done effectively money management can minimize them — and help you avoid losing capital that you cannot afford to lose.
Sensible money management takes the following factors into account:
Risk tolerance Risk tolerance is the level of risk you’re willing to take when trading, or how much money you are prepared to lose without it having a significant impact on your financial situation. Risk is closely tied to reward — the greater your risk, the greater your potential reward and vice-versa — so it is important to get this right. Large returns can seem incredibly appealing, but when they don’t happen, you’re likely to end up with large losses instead.
There are a number of ways we can reduce our risk and ensure that when we incur losses, they are minimized. This includes using a stop-loss, having a positive risk-to-return ratio, and following “the 2% rule.” These can be particularly useful for conservative investors and we’ll look at them in more detail later in this guide.
Trading strategy A vital part of money management is having a sound trading strategy and sticking to it. We have a detailed AAG Academy guide on trading strategies for those who don’t yet have one. This will help you determine the best trades for you based on your goals and your financial situation, and it will help you avoid making decisions that you cannot afford to make.
Just as important as having a trading strategy is ensuring that you stick to it. Your strategy might be perfectly sound, but if you then make incorrect or risky decisions on trades that you weren’t prepared for because you’re frantically trying to recoup losses, you’re likely only going to make things worse, and the trading strategy you have in place then becomes worthless.
What are the benefits of money management?
As we’ve touched on throughout this guide, the biggest benefit of money management is that it can help you minimize your losses, maximize your profits, and protect your capital. This means ensuring that any losses you do incur are affordable ones, and that your overall financial situation isn’t too adversely impacted when one or two trades go wrong.
Without money management, it can be easy to put too much of your capital into trading, which might prevent you from meeting other financial commitments. It can also be easy to make bad trades that, even though they might be profitable, aren’t as effective as they could be. Money management prevents the psychological factor from having too great of an impact on trading.
Money management risks and rewards
Two of the biggest aspects of money management, which you’ll hear everyone talk about whenever this topic is discussed, are risks and rewards. Every form of trading, no matter what the asset may be, comes with some form of risk. Whether or not it is worth it for you depends on the potential reward and the impact it could have on your portfolio.
Let’s say a friend asks to borrow $1,000, and they promise to pay you back $1,100 in two weeks. This is a high risk, low reward situation. If your friend decides not to pay you back, you’ve lost a lot of money, and even if they do, you’re not making much profit. Most investors would likely pay little attention to this kind of scenario.
However, if your friend promises to pay you back $2,000, it becomes a high risk, high reward situation. You’re still going to lose a lot of money if your friend fails to stick to their promise, but you have the potential to earn an additional $1,000 and double your money if they hold up their end of the deal. This is a 2:1 risk/reward ratio, which a lot of investors would find very appealing.
Alternatively, your friend might ask to borrow just $20 and agree to pay you back $25. This is a low risk, low reward situation. You’re not going to lose a lot if the deal falls through, but you’re not going to make a lot if it doesn’t. Conservative investors might be interested in a deal like this because although they won’t see a lot of profit, there’s no chance of a significant loss, either.
Only you can decide what kind of risk/reward ratio works for you. The good news is that when it comes to trading and the wide range of options it brings, you have more control over the level of risk you take. You can pick and choose which cryptocurrencies work for you based on their potential risk/reward ratios, which you can calculate yourself.
To do this, take your net profit (the potential reward) and divide it by the price of your maximum risk. For instance, let’s say you’re interested in a certain cryptocurrency. It is currently trading at $20, but it is down from a recent high of $26, and you’re confident it will rise again. You have $200 to invest, so you buy ten tokens.
The potential net profit on this trade is $60 (since you could make $6 on each of your ten tokens if the price does indeed return to its high), so you divide that by $200 for a risk/reward ratio of 0.3:1. That’s not a very high ratio, so for most professional investors, the trade would not be worth it. However, if you’re more conservative, it may be an appealing opportunity.
Money management tips
If you’re not sure where to start with your own money management plan, here are five tactics that are common among experienced traders:
Use a stop-loss Using a stop-loss order allows you to limit the potential loss you might incur on a trade. Let’s say, for instance, that you purchased 1 Bitcoin (BTC) at a price of $20,000, and you’re worried about a possible crash. You could place a stop loss order at 20% below the purchase price, or at $16,000, so that if the price drops to this point, the asset is sold.
This takes away your option to sit on that asset in the hope that the price rises above $20,000 again, however, it also means that if the price keeps falling and does not recover, you do not lose more than 20% of your initial investment.
Follow the 2% rule Many traders are firm believers of the 2% rule, which dictates that you never put more than 2% of your total trading balance into more than one trade. In other words, if you have $10,000 to trade with, you do not spend more than $200 on a single asset. This is a very conservative approach that is best suited to new traders who want to be particularly careful.
Other investors follow a similar rule but increase the limit to 5% of their account balance. This slightly increases their risk but also their potential reward. The great thing about using a small percentage like this is it prevents you from putting too much of your capital into a single trade, or a single asset, which is what’s known as over-trading.
Never over-trade When you put too much of your capital into a single trade, you greatly increase the risk of a significant financial hit should things go wrong. If you only invest a small portion of your capital at a time, it’s not going to have a huge impact on your overall financial position if two, three, or even four of those trades end up in a loss.
However, if you’ve put a substantial portion of your capital into a single trade, such as 30% or more, that’s going to have a considerable negative impact on your overall position that could mean a very lengthy recovery. Obviously the risk only increases if you over-trade on multiple assets. You can also over-trade by having too many open positions at once.
Even if you follow the 2% or 5% rules, it’s possible to suffer substantial losses if you lose out on too many trades at the same time. If you have 25 positions in your portfolio, and each one has a risk of 2%, it’s not inconceivable that all 25 will go against you at once — that’s actually rather common in the crypto industry. Then you’ve suddenly lost 50% of your account balance.
Never invest more than you can afford to lose Whether you use a percentage rule or not, every experienced trader — even those who like to take big risks — will tell you that you should never invest or trade more than you can afford to lose. This is one of the most important rules of trading. You never want to put yourself in a position where you can’t afford to meet other commitments because of your trading habits.
Before working on your money management plan, it’s important to create a personal budget that will help you establish how much you can afford to trade or invest. This should not only take into account your income and outgoings, but also your financial goals, like saving for an emergency fund or to buy a house. These things should be a higher priority than trading.
Research, research, research Once you’ve got a solid budget and money management plan in place and you’re ready to start trading, the next step is to begin researching. You’ll want to know as much as you possibly can about a particular cryptocurrency before you put any money into it. Find out about the project, the team behind it, what its roadmap looks like, and how the market feels about it.
This kind of information will help you avoid any nasty surprises. No one wants to invest in a cryptocurrency that’s about to make a huge change that could cause its market value to plummet, or one with a shady team that could disappear with all the liquidy at any moment. Making more informed decisions plays a huge part in minimizing your losses in the long-run.
Popular trading strategies in the cryptocurrency industry include day trading, arbitrage trading, scalping, and swing trading. You can read more about these in our detailed guide to choosing the right trading strategy for you.
Crypto asset management is the process of managing your cryptocurrency assets to maximize their value and return — and to minimize your losses. It also includes diversifying your portfolio to minimize the possibility of large losses on multiple assets.
Senior copywriter for AAG Marketing team with the focus of educating our community on all things web3, blockchain and Metaverse.
This article is intended to provide generalized information designed to educate a broad segment of the public; it does not give personalized investment, legal, or other business and professional advice. Before taking any action, you should always consult with your own financial, legal, tax, investment, or other professional for advice on matters that affect you and/or your business.