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Cryptocurrencies Risk Management

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Although there are numerous stories abound of people who have made massive returns on their investments from investing in particular cryptocurrencies, it is also important to understand that there is a lot of risk in these markets.

People tend to always here about that one person who made millions from an early investment in Bitcoin. Or they may have heard of that one guy who made a killing on an investment in an ICO.

However, they don’t tend to hear about the massive failures or people who lost a fortune on an ill-advised cryptocurrency investment.

Don’t Let Hype Drive You
ICO Hype with CryptocurrenciesOne of the biggest enemies to successful investing is possibly your own human impulses. You have to avoid some of the raw impulses that we may feel such as “FOMO” (Fear of Missing Out). When someone is making decisions based on whether they could be “too late to the party” they tend to invest in a cryptocurrency asset that they may not know much about or one that could be peaking.

This cautionary tale shows that you should not automatically expect that past trends will continue forever. Always be wary of imminent corrections in the price that could come at random.

This could also happen in the ICO space if you were invest on an overhyped ICO. Although your analysis says that the project does not really warrant an investment, you may still be tempted to invest based on the amount of press that has been thrown around with regards to the ICO.

Diversification is Key
It has been one of most well-known investment beliefs for almost a century. Keeping all your eggs in one basket is placing a lot of faith in only that basket. This is as true for cryptocurrency as it is for any other asset. If you put all your investments in one token, you are taking a great deal of “idiosyncratic risk”.

Idiosyncratic risk is a term that has been used in traditional finance to describe risks that are not systematic across an asset class or sector. They are limited to only a particular asset and are very hard to predict. For example, a systematic risk in cryptocurrency is regulation, risk aversion sentiments etc. This is something that drives all the assets to a degree.

When you are invested in more than one cryptocurrency asset, the idiosyncratic risk in your portfolio decreases. As you keep adding more coins this unique risk will fall. Theoretically, one would think that an investment in nearly all crypto assets would be a good move.

However, idiosyncratic risk is something which could also help on the upside. The more assets you have, the more you erode your chances of taking part in a rally in the price of the token. Hence, it is wise to find a balance. In traditional investment theory, this would be finding the optimal place on the “efficient frontier” graph. 
Without going too much into the technical aspect of how the Efficient frontier works, it is mainly a balance of risk vs. return. The investor has to try and find the sweet spot between what they want to achieve and the risk they are willing to take.

If the investor has invested all in one coin, then the risk is at the top of the curve. Similarly, if the investor has invested in all coins available to him / her then they would be at the bottom of the curve and this would have low risk but also low reward. The optimal place is somewhere in-between on the graph.

Focus on Ideas, not Tokens
Cryptocurrency Investment IdeasSometimes people can get carried away and invest in a Coin or token merely based on performance or the rumours / buzz around the coin. This is particularly prevalent when people consider investments in ICOs and relatively new coins. However, this is not really the best way to do your due diligence.

It is important that you focus on the idea rather than only the token or the start-up. There are numerous coins that operate in a particular field which you can spread your risk out.

Once you have faith in a particular idea, then you can start to spread your investment out among all of the particular coins within that idea to get the diversification that you are comfortable with.

Hedging With Other Assets
Although you may be quite bullish on cryptocurrencies, once you have a large percentage of your portfolio in these assets it gets harder to manage cryptocurrency risk in general. This is where other asset classes could come in handy.

If you want to hedge some of the systematic cryptocurrency risk in your portfolio then you could look at assets that have a high negative correlation with cryptocurrencies. This would usually be assets such as stocks as they are seen as “risk loving” assets.

The other benefit of using traditional assets to hedge the crypto risk is that you can use a host of derivative instruments such as options and futures. These derivative investments are relatively more affordable because they are unfunded. They only require minimal collateral to hold them.

Of course, as the cryptocurrency derivative market expands, there is hope would be that instruments such as options will give investors the chance to hedge the direct “delta” exposure on their cryptocurrency investments through these options.

‘’ Pro traders use stop losses always. A stop loss rescues you from losing too much in one single trade. Although you do lose sometimes, those losses must be controlled. Only with this control you can make sure that overall you are still winning. ‘’
The Hidden Dangers of Illiquidity
Risks of Illiquidity With CryptocurrenciesThere are many people who will invest in a number of different and rarely traded cryptocurrencies without taking into consideration the impacts of illiquidity. Liquidity will determine how easy it is for you to close out of positions that you hold.

If you have bought a large amount of coins and would like to exit your position, an ilquid market could work against you. Essentially, although the latest price the asset traded at may be “high”, there may not be the buyers who are willing to buy the asset from you at that high.

Moreover, in illiquid markets, the actions that you are taking to trade the coins could lead to adverse reactions in the price. For example, if the market thinks that someone with “inside knowledge” is trying to close out their positions, they may get spooked and dump their holding as well.

This is the worst of both worlds as now not only can you not sell your coins but the price has fallen as a result of the actions that you took.

Hence, the moral of the story is that you should try and invest in coins that are relatively more liquid. This would save you a lot of hassle when it comes to closing out your position at a price that you thought was favourable for an exit position.
The difference between fiat money and digital currencies is that fiat money is issued by central banks, while issuers of digital currencies are decentralized.
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