The risks of trading cryptocurrencies are similar to those associated with any type of trading or investment. However, some unique risks should be considered. Three of them to keep in mind are
- Market volatility
- Security
- Frontrunning
However, the trader’s ability to keep emotions in check will ultimately determine the risk incurred.
Market Volatility Risks of Trading Cryptocurrencies
Volatility is a significant market risk.
Much of it is driven by cycles of hype and then a loss of confidence. Cryptocurrency value is driven by the value placed on them by market participants. Loss of confidence can completely crash a market.
Many traders take advantage of volatility – making many trades (usually using bots to automate the trading process, thus increasing its speed) and often looking for a small return on each one.
However, there are volatility risks for traders.
Slippage
Slippage or “gapping” is when prices change between the time of order and execution. Sometimes the change is so rapid that it skips some price levels, and your stop-loss instruction may be executed at a worse level than you had planned.
CFDs, Spread Betting, and Margin Trading:
Every trading strategy has its risks. However, if you combine them and experience unexpected market volatility, you can have a trading wipe-out!
- In Contracts for Differences (CFDs), traders bet on the direction of price movement. Going long means you are betting on the price going up. Going short is betting on the price going down. At the end of the contract period, the buyer pays the seller the difference between the asset’s current value and its new value.
- Spread betting is an extension of CFDs. Here the trader bets on the spread between the buying price and the selling price – known as the bid/offer or the bid/ask spread – again betting on the direction of movement. You can bet any amount. For example, you may bet $5 per point or “pip” move of the crypto price or $500 per pip.
- Margin trading is where the trader borrows funds to trade. The margin is the amount that you put up (e.g., $2,000). You then leverage that amount with a borrowed amount. So if you leverage x2, that means you have borrowed another $2000, and your trading position is $4,000. A x10 leverage would mean your $2,000 plus a borrowed $18,000 to have a $20,000 opening position.
Volatility can be a problem for all these strategies.
But if you have combined, say, spread betting with significant leverage and the price suddenly drops, not only will you lose your own stake, but the lender might force you to liquidate your position to repay the loan. You will also pay a liquidation penalty imposed by the exchange.
Similarly, if you have bet in the wrong direction on a CFD, you could have a huge bill to pay.
Security Risk
There are several types of security risk.
The Cryptocurrency Itself
Here are some risks to consider before deciding to trade in a particular cryptocurrency:
- Bugs in the code or other vulnerabilities can lead to hacking and the theft of your holdings.
- Fake ICOs, with the hype of capabilities and technical progress, can lure inexperienced traders who are desperate to make a profit.
- Pump and dump schemes (developers or owners driving the price up and then dumping their coins on the market) can lead to a crash in the price.
- If there is insufficient uptake of the underlying business idea or the founders don’t deliver what they promised, the token’s value can drop to nothing.
Crypto Exchanges
There may be problems with the exchange itself, or fees charged may wipe out any trading profit you may make.
Credibility of Exchanges
The more established exchanges are generally credible and trustworthy.
However, there have been breaches, data leaks, and significant losses to hacking at some exchanges – the Mt.Gox and BitFinex stories are well-known.
It’s prudent to be cautious of the many new exchanges and the smaller ones around the world. Many founders or developers of new cryptos set up exchanges specifically to support their tokens. This is particularly risky for traders.
This does not mean that they are dishonest.
However, many lack liquidity, and you might find yourself with a token that you cannot trade.
Exchange Fees
Exchanges generally charge trading fees, deposit/withdrawal fees, interest, and charges for borrowing or liquidation. When traders make many small trades, they risk paying more for the service than their profit.
Exiting a Market
Exiting a market and converting tokens back to fiat can also be expensive. You might have to swap from one currency to another, often on different exchanges, to get to the pair you need.
DeFi Risks
The unregulated and largely anonymous nature of the market makes it ideal for scammers.
An interesting finding is that, to August 2021, cryptocurrency fraud has dropped significantly from 2020.
However, DeFi-related crime has risen dramatically.
- By July 2021, DeFi-related hacks made up three-quarters of all hacks for the year.
- DeFi-related fraud accounted for 54% of all crypto fraud for the year – compared to just 3% in 2020. The majority of these were DeFi rug pulls – someone using funding and vanishing.
Frontrunning in Crypto
Frontrunning is placing a transaction in a queue when you know about a future transaction that will influence the underlying token or coin price.
Crypto miners insert their own transactions ahead of transactions they can see waiting in the queue.
Or traders can watch the mempool on a decentralized exchange (DEX) and see the transactions waiting for confirmation and the offered gas fees. Frontrunners use bots to put in their bids with higher gas price offers so that miners will prioritize them at the expense of earlier trades.
Frontrunning significantly impacts arbitrage traders who are betting on tiny movements in price. However, it is a growing problem for equity trade, options, futures contracts, and derivatives and is a significant reason for the wariness of institutional investors.
The Biggest Risk of Trading Cryptocurrencies is Human Emotion
Risks of trading cryptocurrencies can be minimized by having a clear trading strategy before trading – and sticking to it.
The danger is when FUD (fear, uncertainty, and doubt) or FOMO (fear of missing out) overwhelm traders, and they change strategy in the middle of a trade.
Crypto trading can be very lucrative, but it is also very risky. The basic rule is never to trade more than you can afford to lose.
