After the $20 billion liquidation disaster, how can crypto traders rebuild their risk defenses?

Written by: Spicy

Translated by: Luffy, Foresight News

Original Title: After $20 billions in Liquidations, Crypto Investors Must Master These Risk Management Strategies

The epic $20 billions liquidation event that occurred over the weekend taught many crypto traders a profound lesson. The importance of risk management is often overlooked. Veteran crypto trader Spicy shares 5 key risk management insights: from understanding the formula for long-term profitability, to leveraging methods to avoid liquidation, and practical ways to control bet sizing. These methods may help investors go further and last longer in the crypto market. The following is a translated summary of the article:

There are many important aspects to trading, but nothing is more important than risk management.

I was once a professional trader and have been trading cryptocurrencies for 8 years. Thank you for taking the time to read this article. In return, I will share all the risk management knowledge I know with you, without reservation.

Expected Value (EV) Formula

Expected Value Formula: EV = (Average Profit × Win Rate) – (Average Loss × Loss Rate)

Tip: Expected value refers to "the average result you can expect when you repeatedly make the same decision."

Every trader must understand the concept and calculation of expected value. Why is expected value so important? The expected value of trading helps us estimate "the profit we can expect after making N trades in the future."

For example, if the expected value of each trade is +$10, then after making 1000 identical trades, your expected profit is about $10 × 1000 = $10,000.

• If you have a positive expected value (+EV), you will be profitable in the long run;

• If you have a negative expected value (–EV), you will eventually lose money in the long run.

Next, I will introduce "Monte Carlo Simulation," which can visually present the actual effect of expected value.

Monte Carlo Simulation

First, a quick look at Monte Carlo Simulation

Suppose a trading strategy has a win rate of 55% and a risk-reward ratio of 1:1. We simulate the performance of 1000 trades 30 times. This is a profitable strategy with a positive expected value (+EV).

Tip: Monte Carlo Simulation refers to predicting all possible outcomes after N trades by running a large number of random hypothetical scenarios.

Monte Carlo Simulation helps us manage expectations and roughly judge the profit potential of a strategy.

Simply enter the initial capital, win rate, average profit and loss ratio, and number of trades, and the simulation program will generate random combinations of possible trading performances.

The thick black line in the chart represents the average expected result: if the expected value of each trade is +$10, after 100 trades, the total profit is about +$1,000; after 1000 trades, the total profit is about +$10,000.

Please note the word "about," because results cannot be fully guaranteed and there may be some variance.

Next, a quick look at variance

Whether you like it or not, randomness will affect trading performance.

Using a coin toss as an analogy: suppose you play a coin toss game, and the probability of heads and tails is 50% each.

If you toss the coin 10 times, you might get 8 heads and 2 tails; although the probability of heads should be 50%, the actual occurrence is 80%.

This does not mean the coin is rigged or that the probability of heads is 80%, it’s just that the number of tosses is insufficient for the probability to fully reveal its true distribution.

The difference between the actual result (80%) and the theoretical probability (50%) is the variance (80% – 50% = 30%).

If you toss the coin 10,000 times, you might get 5,050 heads and 4,950 tails. Although the number of heads exceeds expectations by 50, as a percentage, the variance is only 0.5% (50÷10,000).

Finally, a quick look at the Law of Large Numbers

The more times you toss the coin, the closer the variance gets to 0.

Tip: The Law of Large Numbers states that the more times a random event is repeated, the closer the result gets to its true average value.

If you only toss the coin 10 times, the variance in the probability of heads may be large; if you toss it more than 10,000 times, the variance will be very small.

Simply put, the more times an event occurs, the closer the result gets to the true probability.

How are Monte Carlo Simulation, variance, and the Law of Large Numbers related to trading?

Monte Carlo Simulation helps us manage expectations based on variance and judge the possible performance of N trades in the future; the more trades, the smaller the expected variance.

It can also answer these key questions:

• After N trades, what is the expected profit?

• What is the maximum number of consecutive wins that may occur?

• What is the maximum number of consecutive losses that may occur?

• With the current win rate and risk-reward ratio, after N trades, what percentage of account loss is within the normal range?

At the same time, it also brings a reality check:

• Even highly profitable strategies may experience long-term drawdowns (drawdown refers to the percentage of account loss);

• Even high win rate strategies may experience significant consecutive losses;

• Even low win rate strategies may experience significant consecutive wins;

• The result of the next trade does not matter; what matters is the overall result of the next 100+ trades.

Key takeaways from this section:

• Sometimes you make a good trade but still lose money;

• Sometimes you make a bad trade but unexpectedly make a profit.

The occurrence of these situations is due to variance (or luck). It is not advisable to judge whether a trade is correct based solely on the result of a single trade.

Two extreme examples:

• You place an order based on a trading strategy with a 90% win rate and a 1:1 risk-reward ratio. Even if this trade loses, it is still the right decision. Because if you repeat the same trade 1000+ times and let the Law of Large Numbers work, you will inevitably be profitable in the end.

• You play slot machines in a casino. Even if you win once, it does not mean it was a wise bet; it was just good luck due to variance. If you keep betting 1000+ times and let the Law of Large Numbers work, you will eventually lose all your money.

Key conclusion:

Do not judge the quality of a trade based on the profit or loss of the next trade, but on the expected value of the trade. You need to be patient and endure some variance for profits to gradually appear.

Leverage and Liquidation

Leverage may be one of the most misunderstood concepts among traders.

Before reading further, remember that you don’t need to memorize all the details or feel pressured. As long as you grasp the basic concept of leverage, you’ll be able to handle trading.

Let’s do a quick test to see if you understand the basics of leverage (assuming both traders have the same entry price).

Most people have a misconception about leverage (absolutely wrong): Leverage is a profit multiplier; increasing leverage will magically increase trading profits.

I can say with certainty that leverage is not like this at all.

The real function of leverage (correct): Leverage is a tool to reduce counterparty risk and improve capital efficiency.

Counterparty risk: Refers to the risk you face by holding funds on an exchange. The exchange may run away or commit fraud (such as the FTX incident), so funds are not absolutely safe.

Capital efficiency: Refers to the efficiency with which you use your funds to earn more profit. For example: earning $1,000 per month with $1,000 capital is 100 times more efficient than earning $1,000 per month with $100,000 capital.

Before going deeper, let’s clarify the definitions of a few terms, then return to leverage.

• Trading account balance: The total funds you are willing to use for trading;

• Exchange account balance: The funds you deposit into the exchange, usually only a small part of your trading account balance. It is not recommended to deposit all your trading funds into the exchange;

• Margin: The deposit required to open a trade;

• Leverage: The multiple of funds you borrow from the exchange;

• Position size: The total amount of tokens (or their USD value) you actually buy/sell in a trade.

Additional note: The diagram below shows my process for managing deposits and withdrawals on exchanges. The core principle is "do not concentrate all funds on a single exchange to avoid excessive risk exposure."

Understanding the above concepts through an example

Suppose you have $10,000 available for trading. This is your trading account balance.

You are unwilling to deposit all $10,000 into the exchange (worried about the exchange freezing funds, fraud, or hacking), so you only deposit 10%, which is $1,000. At this point, your exchange account balance is $1,000.

You spot a good trading opportunity in bitcoin and want to go long $10,000 worth of BTC. When you click buy, the system will prompt you that you have insufficient funds, because your exchange account balance is only $1,000. You need to use leverage to borrow the required funds to open the position.

After setting leverage to 10x, click buy again to successfully open the position:

• The position size (actual value of BTC bought) is $10,000;

• Margin (your deposit) is $1,000;

• Leverage multiple is 10x.

Tip: Whether you use 1x or 100x leverage, the profit from a $10,000 position is always the same. The nature of a $10,000 position does not change with leverage. Even if you adjust leverage during the trade, it will not affect the final profit.

The purpose of liquidation

When you use leverage to open a position, you are essentially borrowing money from the exchange. These funds are not created out of thin air.

If you open a $10,000 position with 10x leverage and your exchange account balance is only $1,000, then $9,000 is borrowed from the exchange, and this borrowed money can only be used to open the position.

To ensure the exchange can recover the funds it lent out, there is a liquidation mechanism.

Liquidation: If the price hits a certain point (the liquidation price), the exchange will forcibly close your position and confiscate your margin. After that, the position will be taken over by the exchange, and any subsequent profit or loss will have nothing to do with you.

Understanding through analogy

Suppose you are optimistic about a new iPhone, currently priced at $1,000. You expect it to rise to $1,100 (a 10% increase), and plan to buy at $1,000 and sell at $1,100 to earn a $100 profit.

But the problem is, you only have $100 in your bank account.

So you find a rich guy, Timmy, and borrow $900 from him to make the iPhone trade.

Potential risk

If Timmy lends you $900 and the iPhone price drops below $900, even if you sell the iPhone, you cannot fully repay Timmy’s loan. Timmy would lose money for no reason, and he does not want to bear this loss.

Solution

The two parties sign a mutually beneficial agreement (the essence of a perpetual contract is an agreement between the trader and the exchange):

You and Timmy agree: if the iPhone price falls below $910, you must hand over the iPhone you bought to Timmy, which is equivalent to your position being liquidated.

At this point, you lose the initial $100 you deposited (margin); Timmy will try to sell the iPhone himself; if the price does not fluctuate much and he can sell it for more than $900, he will make a profit.

Timmy requires "taking over the iPhone if the price falls below $910 instead of $900" because he deserves a reasonable return for "lending you money." This gives him enough room to "sell the iPhone and recover his principal."

Key takeaways from this section

You don’t need to memorize all the term definitions. The most important thing is to understand that leverage is just a tool to help you get the position size you want.

Also, never put yourself at risk of liquidation. The cost and fees of liquidation are extremely high.

Tip: Every trade must have a stop loss. Trading without a stop loss is extremely risky.

The Difference Between Position Size and Risk

Another concept often misunderstood by traders is the difference between position size and risk.

Position size refers to the total amount of tokens (or USD value) involved in a trade. For example: I bought $10,000 worth of BTC, so the position size is $10,000.

Risk refers to the amount of money you will lose if your trade is wrong and you need to stop out. For example: if the price hits the stop loss, I will lose $100, so the risk is $100.

Before making any trade, I always ask myself: "If I’m wrong and have to stop out, how much loss can I accept?"

This is a key question, but many traders completely ignore it. They firmly believe their trading idea is absolutely correct and cannot be wrong, and with the influence of FOMO, they often end up in trouble.

After determining the acceptable loss amount for the next trade, the next step is to calculate the required position size.

You don’t need to worry about doing math before every trade; there’s a simpler way.

TradingView’s risk-reward tool has built-in calculation functions:

It’s very simple to use. Let’s move on to the final key point