02 June 2022
4 min read
Decentralized finance (DeFi) has completely transformed the cryptocurrency market. Traders are interested in this domain, both as a promising infrastructure project within the crypto industry and as an opportunity to profit off turbulent token fluctuations.
At the same time, this turbulence has a flip side: a rather high risk. Let’s go through a few strategies for the DeFi market that can minimize these risks on a DeFi protocol.
From the beginner phase, investors adored the DeFi investing domain, since decentralized finance gives them more control over their money. And while early on decentralized finance floated toward loans and credit, DeFi is now at least 5 full-fledged, interconnected fragments: blockchain, decentralized exchanges (DEX), decentralized derivative platforms, loans and credit, & insurance.
Despite its relative firmness, the DeFi segment is still prone to risks, as an investment. The volatility in the tokens of various projects undeniably pulls new investors. However, high yield also means high risk. There are several efficient ways or strategies for managing risks in DeFi.
Strategy #1: Position Sizing
Position sizing formulates how many crypto coins or tokens a trader is willing to buy. The probability of realizing huge profits in crypto trading tempts traders to invest 30%, 50%, or even 100% of their trading capital. However, this is a disordered action that puts you at serious financial risks. The golden rule is: never put all your eggs in one basket. Here are three approaches to achieving position sizing.
- Enter Amount vs Risk Amount: This approach considers two different capitals. The first involves money you are willing to put in every single deal. Traders are advised to analyze this amount as the size of each new order they take, regardless of its type. The second is the money at risk, i.e. the money that you afford to lose if the trading fails.
- Elder’s Sharks & Piranhas: This approach relates to diversifying your investments which brings forth two basic methods:
Limiting every position to 2% risk. Dr. Alexander Elder, who is credited with the concept, correlated risk to a shark bite. At times, you would wish to risk a huge capital, but the risk would be huge and disastrous as a shark bite.
Limiting trading sessions to 6% per session. In a losing streak, you may end up disposing of everything you own little by little. Elder correlates this risk to a piranha attack, which takes small bites of its victim until it devours it all.
- The Kelly criterion: It is a formula developed by John Larry Kelly in 1956. It is a position sizing approach that defines the percentage of the amount to risk. It enhances long-term trading.
Strategy #2: Diversified Portfolio
In this strategy, investors fill their portfolios with the most assuring, underrated, and non-overlapping DeFi projects. This compresses the risk of the portfolio losing significant value because of a single asset. You can identify assuring tokens by their market cap to total value locked (TVL) ratio. Tokens with the minimal correlation of these values can be considered underrated, which means there is logic to expect these assets to “catch up” with others in their valuation and growth. Therefore, by buying these cryptocurrencies, traders stabilize their portfolios for the medium & long duration.
For additional diversification of your risks, you can choose projects on different blockchains, such as Ethereum or Binance Smart Chain. Another way is to select negatively correlated tokens, meaning that when one token is highly turbulent in day trading, you should choose a more stable asset for balance.
Diversifying your portfolio by including an insurance project is even better since the demand for safeguarding capital within the decentralized finance ecosystem is only going to increase. Having such tokens in your investment portfolio will help you to significantly counteract an adverse situation if one were to suddenly occur.
Strategy #3: Staking
You can also minimize your risks of value loss with stake-able tokens. The cryptocurrencies of certain DeFi projects offer the feature to profit just by storing them. For example, users of the international cryptocurrency exchange CEX.IO can earn up to 16% annual interest for storing their tokens. And the gain from staking rises when the coin’s price rises. For example, if a trader invests $100 in XYZ token at $0.20 per coin, with 16% interest for staking they would get approximately 580 XYZ at the end of the year as their reward. If in that period the price has increased from $0.20 to $0.40, the trader would get $232 when they cash out. Considering the coin’s price surge, the profit increases to 132% instead of 20%.
To safeguard your portfolio against major fluctuations, you can invest in stablecoins that provide staking, such as Dai. On one hand, the passive yield from your tokens can increase your total profit from investing in the DeFi sector, and on the other hand, it can cushion potential losses if the market ramps down. Additionally, traders can restrict their losses to the amount of their prospective staking reward. As soon as the losses on their positions get near to the profit they would get from staking, traders can simply close them.
Strategy #4: Hedging
In the fundamental hedging process, while buying an asset on an exchange, traders open an opposing position in the associated derivative at once. These derivatives could be futures, alternatives, or contracts for difference. So if a trader buys XYZ on the exchange, to hedge the risk of the asset losing value they would immediately sell a contract for a difference for the same amount. In the end, if XYZ gains in price, the losses on the contract for difference would be cushioned by the rise in the cryptocurrency’s value. However, if the price for XYZ decreases, this difference would be covered by the contrasting position on the contract for difference.
Derivative trading is offered by specialized platforms where you can use them to gain from turbulence in the prices of cryptocurrencies without having to physically buy them and hedge assets you’re holding. A contract for difference permits traders not to participate directly in DeFi and escape the technical risks, uncertainty, and complexity linked with it. To manage risks, most of the platforms use automatic safeguard orders, such as stop-loss and take-profit.
Many platforms allow users to draw out maximum profit from fluctuations in the DeFi market and, if necessary, apply strategies to efficiently protect their capital.