From the very beginning, cryptocurrencies have faced the problem of mass adoption, partly because they are new and incredibly innovative, partly because they are decentralised and involve money with no-one backing it, which is an issue for people as cryptocurrencies involve money. People, unless they are totally aware and fine with the risks that cryptocurrency investments pose, do not want to inject their money in a system that doesn’t have anyone responsible if anything goes wrong with their funds. In short, they don’t want to risk their money.
Through this chapter, I aim to help you understand various kinds of risks that exist in cryptocurrencies and explain how you can identify and reduce these risks, so that each decision you take to trade or invest in cryptocurrencies, is informed, and thus, well-calculated.
Following are different types of risks in cryptocurrencies, which we will understand one by one, as we move forward:
- Market Psychology Risks
- Security Risks
Even though cryptocurrencies are just like conventionally traded assets, the prices of which vary as per the change in demand, there are few factors due to which the price graph of former, except stable coins, doesn’t look similar to that of the latter. The reason behind that is, first off, cryptocurrencies do not hold intrinsic value, as in they do not have a product or service backing them, unlike shares of a company. This makes it difficult even for expert investors to determine their value. Fundamental analysis of cryptocurrencies, at present, is not very effective as most cryptocurrencies are relatively new, which is why not a lot of analysable data is available. Another reason would be non-uniform distribution of cryptocurrency wealth. There are large cryptocurrency investors, also called ‘Whales’, who possess the ability to change the market in an instant, by moving large chunks of cryptocurrency funds.
However, anyone who says that little can be done about the volatility issues in crypto is on the wrong side of the spectrum. Volatility issues can always be tackled with proper trading tools. And when I say trading tools, I basically mean different types of trade orders your exchange allows you to use. Apart from that, there are few other types of risks that can be alleviated by just playing it carefully and following a few tips and tricks. After we are done understanding all types of risks, we will look at the order types and how each order type has a different utility in the market. But for now, let’s move on to the next type of risk.
There is a massive number of cryptocurrencies popping up in the market, almost everyday. Does that mean all of them are good for investment? Does that mean you should be investing in each to diversify your portfolio? A concise answer would be – No. You should be carrying out your research and not be following the hype. In a massive majority of cases, seed investors were not refunded by the projects that failed. So, most definitely, investing in a cryptocurrency or an upcoming project just because of the hype would not be a wise decision. And while it may sound impossible that you need to research each and every project you will ever invest in, practically it is not that complex. You just need to apply some common sense and be observant of a few project-related factors like:
Project’s founding team
The project’s founding team must have proven expertise. Gradually, as the utility of blockchain became clearer, technology experts with substantial background in conventional technologies have joined the blockchain revolution. So always do a little background verification of the founding members of a blockchain project.
Not to be taken lightly, white paper is the complete technical document of a blockchain project. Read it to get an idea about the mission, aim, use cases and future of a blockchain project. Understand it, discuss it with people who understand cryptocurrencies and blockchain technology, and If it still sounds bogus, do not invest your money in it.
Product/service’s functioning model
If it functions the way its white paper promises, it is less likely to fail, given that it has proven its utility at tackling a widely identified challenge. For example – Bitcoin solved the issue of decentralised payments, Ethereum found a way to execute tasks in a digital, tamper-proof way and so on.
Ratio of tokens issued to net worth
What amount of tokens are released during an ICO against what amount of tokens are being held with the founding team needs to be checked. If the team held a significant amount of tokens with them without any pre-planned schedule to release a fair amount in future, it may indicate that the project is not truly decentralised because financially it is largely in the hands of stakeholders.
Noticeable developments and collaborations – Any new developments in a blockchain project, or any project for that matter, is a sign of growth. But don’t fall prey to advancements of minuscule importance.
Risks emerging out of Market Psychology
Irrespective of how advanced we get, the truth is that markets are created and run by humans. And with humans, comes human psychology. In general, when the market goes down, humans will panic and sell. And when it goes up, humans are in a hurry to buy. And that is how it has always been. Fear and excitement are two major reasons behind failed investment.
In the world of cryptocurrency investments, there are two highly recognised jargons that you would often hear of: FOMO and FUD. Let’s understand what they are.
Has it ever occurred to you that you invested in a rising market because everyone was investing, but eventually, you incurred losses due to sudden fall in market? If yes, then what you experienced was Fear of Missing Out (FOMO). I witnessed a clear case of a FOMO victim, who also happened to be a friend of mine, at the time when BTC crashed in December 2017. I invested in BTC when it was around 3,00,000 INR per BTC. So when the market touched 6,00,000 INR, I couldn’t be happier. The market rose to 10,00,000 INR which was unbelievable. At this point, my friend felt that he was missing out on an opportunity but still could not gather the courage to invest because he felt that the spike was so sudden that the market could crash anytime. I kept telling him to invest in BTC as the market looked good. I persuaded him for another 2 days when BTC was at 14,00,000 INR, and by now, his fear of missing out on the opportunity heightened to such a degree that he gave up to the pressure and invested when the market was at 14,50,000 INR, after which the market crashed to land up at 7,00,000 INR and then back to 3,00,000 INR and even lower. He invested around 20,000 INR, which shrunk to about 4,000 INR within a couple of weeks. Today, he doesn’t believe in cryptocurrency investments. But who’s to blame? Not me. So remember, never succumb to FOMO. Take a good look at the market, use what you learnt in technical analysis and then decide whether it is the right time to enter or exit the market.
Fear, Uncertainty, Doubt – that’s what FUD stands for. FUD is created when an unexpected event that could affect the cryptocurrency market takes place or is rumoured to take place. A classic example of FUD would be when the market crashed in late 2018 because China banned ICO and cryptocurrencies in the country. FUD rapidly developed among the masses and the market crashed badly within a matter of hours. To avoid the impact of FUD, the best approach is to always stay updated with the latest global news around cryptocurrencies, either convert your cryptocurrency funds to USDT or withdraw your funds into your bank account when you see a possibility of FUD, and stay until the FUD passes. At any given time, converting your funds to avoid FUD would be a better option because converting to USDT would always be faster.
Limiting volatility risks with different order types:
When we talk about the risks in cryptocurrency trading, it basically means we are implying the consequences of missing a trade opportunity, which consists of both the aspects of it – generating profit and avoiding loss. And in plain terms, the likelihood of missing an opportunity during cryptocurrency trading is amplified when the market is volatile because the rise and fall of market price is sudden during this phase. Hence, the more volatility, the more the risk.
That said, as with price volatility come bigger profit-making opportunities, volatility risk is actually a necessary evil in cryptocurrency trading, given that you have all the right trading tools for each type of opportunity, regardless of the magnitude of risk it involves.
At this juncture, I would recommend all my readers to use Bitbns for trading cryptocurrencies. And it is not because what you are reading has been brought to you by Bitbns, but because the types of trading orders and features that Bitbns offers, are not available in other Indian cryptocurrency exchanges. Also, in terms of transparency, Bitbns has been ranked 1 in India by Blockchain Transparency Institute.
Anyway, now let’s understand how you can limit volatility risk with different types of trade orders:
Limit orders are simple. You specify the maximum price you are willing to pay when you are buying and the minimum price at which you want to sell. Since the price here is specific, your order is fulfilled at the same or better price. So basically, if you set a limit order to buy XRP at 30 INR, limit order would make sure your order would be fulfilled at 30 INR or below if the market moves hits or crosses the price you specified. However, the risk here is that you may miss a trading opportunity if your buy or sell price is unrealistic, as there would be no sellers or buyers willing to trade with you at that price point.
So, reducing risk in case of limit orders comes from being careful about the price you set. For example – if you place a buy order for some cryptocurrency at Rs. 10 i.e you want to buy some quantity of it at the price of Rs. 10, when its market price is Rs. 9.80, your order will most likely be fulfilled, but if you set the buy price @ Rs. 8.20, you will rarely find a buyer willing to sell at a lesser price because the sellers would not be willing to bear a loss. And vice versa. You saw an opportunity but to get the coin at an unrealistically low price, you might have missed the chance to enter the market at the right time. Even though you would cancel the order after waiting for a long time for your order to get executed, you may have missed a trading opportunity.
The best way to avoid missing an opportunity with limit orders is to stay realistic and be willing to pay at par with the market price or better. Check the live order book to determine the order value and place a fair order. Since limit orders specify a specific price point, in most cases, they are used to purchase cryptocurrencies at market price or best price offered at that point.
So in case of limit orders, you learnt that reducing risk depends on how fair your limit order seems to other traders. However, with stop-limit orders, reducing risk does not come only from how smartly you place the order, but also from the stop price that you define.
Stop-limit orders are made up of two components – stop price and limit price, and these kind of orders are best to use when you are not sure about the momentum of the market. Let’s say you want to buy Ethereum only when its market is progressive. In that case, using a stop-limit order, you can purchase Ethereum only when the market gains a certain degree of momentum and reaches a price point at which you want to enter the market.
Straight up, the advantage of using a stop-limit order is that you can clearly define how much profit you intend to make after the price of the cryptocurrency hits a certain price point. Let’s say the market price of cryptocurrency A is 30 INR and you want to enter only when the market reaches 40 INR and keeps going up so that you can generate profit by selling at a price above 40 INR. Here, you can place a stop-limit order, where stop price is, say, 37 INR and limit price is 40 INR. With these values in place, your order will be executed only when the market starts moving up from 30 INR and hits 37 INR. Only when the market hits 37 INR, your order will be displayed to sellers supposed to fulfil the order. Since the market has momentum at this point, setting a higher sell price at, say, 44 INR would be a good return. If you could get more, that would be even better.
From the perspective of risk management, stop-limit orders manage risk by allowing you to decide exactly when you want to enter the market and lock profit in a much more concise way. But then there is a third type and that’s what I would say is the best way to beat the market.
Bracket Orders are made up of three different types of order – entry order, target or exit order, and stop limit orders. Talk about risk management, Bracket Orders are, straight up, your best shot at managing risk via trading tools. With the help of an example, I will explain the need for bracket orders.
Let’s say the market price of the cryptocurrency A is 30 INR and at this price, you enter the market by purchasing A. Now, your goal would obviously be to sell at a higher price in order to make a profit. So let’s say you place a sell limit order at 35 INR. If the market hits 35 INR , your order would be executed and you would clearly have pocketed a profit. But what if the market went down? What could have been the regulation to cover this? The answer is Bracket Order.
Bracket Orders allow you to define profit as well as set downside protection. Now let’s see how things would have turned out differently if you had placed a bracket order.
You set the entry order at 30 INR, target order at 35 INR and stop limit order at 28 INR with a trail of 20 paisa. This means you entered the market at a desired price, defined the profit via target order, and reduced risk by placing a stop-limit order. But hold on a second; I also mentioned a trail of 20 paisa. What does that mean? It means that the stop-limit is intelligent enough to adjust itself according to the rise in market price. So, a trail of 20 paisa means that every time the market moves up by 20 paisa, the stop-limit would also increase by 20 paisa for every 20 paisa increment in the market price. For example – if the market moves from 30 INR to 30.40 INR, the stop-limit would also go up to 28.40 INR. But if the market falls back to 30.20 INR, the stop-limit would stay firm in its place at 28.40 INR. Check out this bracket order explainer video to understand better:
As quite apparent from the way it enables traders to define entry, exit and probable loss, bracket order is the best at effectively reducing risk even in a highly volatile market.
Margin trading allows a trader to either borrow or lend cryptocurrency funds. Using Margin Trade, a borrower can make more profit by trading more, and a lender can simply earn interest on the funds they lend. If you want to learn more about margin trading, you can go through Chapter-X of module 1.
Moving on, with margin borrowing, one can almost double their profit, and with margin lending, technically, one can earn upto 20% annual interest on their funds. There is no doubt that margin trade sounds great, especially in the way it boosts returns.
But then, as there is risk involved in just about anything and everything, both the borrowing and lending aspects of margin trade involve risk. Something I would like to mention here is that if margin trade can amplify gains in a favourable market, it can also amplify losses if you act greedily in an unfavourable market.
Taking a margin loan against your net worth on Bitbns is quite simple. And if you succeed in the market, you can easily return the margin + interest, and pocket the rest as a profit. But in case the market moves unfavourably and you fail to limit your loss, your cryptocurrency exchange would take appropriate steps before your investment shrinks enough to repay the loan. These steps could also be termed as corrective actions. The corrective sequence starts with a margin call and ends on liquidation of funds, which means you end up losing your investment.
So how can you mitigate this risk? I would always recommend you to use bracket orders when you take a margin loan. With a bracket order, you can pre-define the amount of profit you want to make out of a trade and avoid taking decisions driven by FOMO, FUD and other market events.
The most important thing to remember when you take a margin loan is that you should always make sure you exit the market before you receive a margin call from your exchange, and bracket orders help you do just that. Do not let greed drive your trade decisions especially when you borrow funds. Remember, it’s not your money.
The only risk that margin lenders run of is the drop in price of cryptocurrency after they have already lent their funds. For example – if lender A lends at cryptocurrency X @ 10 INR, and the market take a plunge to reach 2 INR, the value of funds that the lender gets in return would be 5 times lesser than what they lent.
So what do think you can do to reduce the risk of losing the value of your investment? It’s simple. On Bitbns, there are actually two ways of mitigating risk for margin lenders:
Lend in USDT
When you lend in USDT, you simply eliminate the fear of losing the value of your investments because USDT is a stable coin and its value is always pegged to the value of United States Dollar. Therefore, its worth does not erode with the change in market price of other cryptocurrencies.
Let’s suppose you have 1 BTC and you plan to lend it. The only fear you have is that if the market price of BTC starts going down, you would not be able to liquidate your cryptocurrency in time because your funds are locked in until the borrowing party returns it.
Nothing to worry about because margin borrow comes in handy in this situation. So you can actually follow these steps to avoid a loss:
Assumptions: You have 1 BTC to lend. Current price of BTC is 300,000 INR and the market falls to 50,000 INR the next day.
- Before lending your 1 BTC, borrow 1 BTC via margin borrow and sell it immediately at the current market price to get 300,000 INR. Keep the money with you.
- Now the market falls to 50,000 INR. When this happens, the value of 1 BTC that you lent reduces to 50,000 INR from 300,000 INR. But it is still 1 BTC, right?
- Use this 1 BTC to settle the margin loan.
- Buy 1 BTC with 300,000 INR that you got by selling 1 BTC in the beginning of trade.
- In the end, you still have 1 BTC, plus the interest you received for lending 1 BTC.
So basically, what’s happening here is that you borrow 1 BTC using margin trade and sell it to GET 300,000 INR in order to keep your investment intact. Then, you lend the 1 BTC you already had. If in the worst case scenario, the market falls and the value of your 1 BTC becomes 50,000 INR, it won’t be a problem because to repay the margin loan, you don’t need 1 BTC that values 300,000 INR. You just need 1 BTC, no matter what its market value is at that point of time. So, even if your 1 BTC values 50,000 INR, you can still use it to repay the margin loan of 1 BTC.
The kind of risks that emerge out of security hazards are called security risks. And when I say security hazards, I mean directly or indirectly sharing the access of your Bitbns account with a stranger/scammer.
Since cryptocurrency market is yet not regulated in India and most other countries, the sector is full of traps laid by scammers. To reduce security risks, you will have to keep a few security tips in mind:
Beware the Phisher’s Bait
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