Risk management indicators in crypto

Neglecting risk management when things are going well and profits are high, is one of the main reasons for future failure when a bear market starts.

Always remember that the crypto market can undergo dramatic mood swings, so you must exercise extreme caution even when there is no reason for concern. There are special risk indicators that crypto companies must always employ, as well as individual investors as additional insurance.

Value at Risk (VaR)

This indication will let you know if a bad scenario is about to occur. It helps to measure the level and probability of the maximum expected potential loss that a company or an investor can afford within a given time period. VaR indicates possible losses in 90%-99% of cases.

Calculating VaR involves simulating a large number of possible market scenarios and using a statistical model to estimate the probability of incurring a loss.

VaR indicator illustration. Source: Darwinex.

Expected Shortfall (ES)

The biggest downside of the Value at Risk indicator is the lack of data on losses above the VaR level. This is where the Expected Shortfall indicator helps by displaying the average quantitative losses after reaching the VaR level. This indicator is especially useful for volatile assets such as cryptocurrencies.

ES is calculated by averaging returns and VAR values. For instance, for a 95% confidence level, the expected shortfall is calculated by taking the average of returns in the worst 5% of cases.

However, ES is unstable due to its sensitivity to extreme events. Expected Shortfall is difficult to determine without making additional forecasts about the distribution of losses beyond the VaR threshold.

Implied Volatility (IV)

It’s an option trading indicator that shows the expected volatility of contracts over their life.

IV informs about the likelihood of an unstable change in the value of an asset, since volatility is correlated with supply and demand for a particular option contract, as well as with the expected direction of the price movement.

This indicator is positively correlated with an asset's expected price. It is also considered an important element in predicting an option’s price. If market participants believe that a crypto price will rise in the future, the implied volatility will also increase. If investors expect the price to go down, IV will also decrease.

Therefore, implied volatility can be used in risk management to completely examine the market scenario using volatility.

An illustration of implied volatility. Source: Coindesk

Liquidity

Liquidity indicates how quickly you can sell or buy an asset. Liquidity risk arises when it is no longer possible to sell an asset rapidly at market price without incurring large losses. The lack of using this indicator played a significant role in the collapse of Celsius and FTX. After analyzing the spot markets for stETH and FTT tokens, holders could notice that there was almost no liquidity.

Furthermore, not so many people were buying the FTT on other than the FTX exchange to withstand the massive bearish pressure throughout the scandal. The liquidity was 2% ($6 million) of the average pre-bankruptcy FTT value. Such dramatic consequences could have been prevented with proper risk management. To predict large liquidations and price fluctuations, follow the asset’s liquidity across centralized and decentralized markets.

Generally speaking, risk management is something that crypto companies and investors should keep in mind if they want to save their capital during a long bear trend.