Understand the Basics of Trading Cryptocurrencies

Understand the Basics of Trading Cryptocurrencies

Cryptocurrencies can be traded in many different ways which, in the end, aren’t very different from the stock, option and derivative markets. The same models used in centralized stock markets were applied to cryptocurrencies, adjusting the business rules and systems to the technology used in crypto deposits and withdrawals. In fact, after deposits are confirmed, the most popular crypto trading systems are very similar to stock market trading systems.

In this article we take a look at the basics of trading cryptocurrencies, in the hopes that new investors will get an overall view of how trading works, how exchanges work and what the main differences are between centralized and decentralized cryptocurrency exchanges.

Why invest?

First of all, what is your goal investing in cryptocurrencies? Many speculators were attracted to cryptocurrencies on the first crypto boom in 2013, only to face a bear market in the following year. Then came 2017 and Bitcoin went mainstream, all the mainstream financial news outlets started covering Bitcoin, major New York exchanges adopted Bitcoin and several large scale legal, financial and market changes happened in several countries, from South Korea to China to the USA.

Given this immense media exposure, Bitcoin soared to unprecedented prices. Those who invested a few thousand dollars in early 2017 had multiplied their money over 10fold by the end of the year. Bitcoin peaked at over U$20000 and many predicted it would reach hundreds of thousands of dollars within months.

Investors flocked to Bitcoin, but many ended up entering at the very top. Folks who bought Bitcoin in december of 2017 are now 60% down from their initial investments. But there’s always the promise that it’ll go back to tens of thousands of dollars of value soon. The arguments are compelling: there will only ever be 21 million Bitcoins mined, there are more millionaires in the world than there will ever be Bitcoins, therefore not all the rich can own a Bitcoin. The mining cost per Bitcoin will also be in thousands of dollars soon, forcing the Bitcoin market value up higher than it costs to mine them, or else miners couldn’t cover their own costs. Will Bitcoin survive when mining it becomes more costly than each coin is worth? Will there continue to be miners when the reward halves again and mining costs double overnight? These are all valid and still open questions. The truth is nobody knows.

In such a risky environment, what is your end goal investing in Bitcoin and other cryptocurrencies? Is it growth investing? Will you be preparing for your kids’ college? Or are you a speculator with no stops or risk management? Thousands of investors fit into this last segment. They’re reckless and they’re willing to lose everything. In fact one motto in crypto investing has been “invest what you can afford to lose”. Which is true in the end, since a lot of the more irresponsible speculators work with leverages up to 100X. When they’re liquidated, and it happens often, many of these speculators end up owing their homes, cars, savings and everything else they don’t own. This category of speculation is plain simply gambling and like any other gambling the stats are solid against the speculator, 99.9% of these speculators fail in the long run. Like any other game, most are kept in the game by having hit one or a few big homeruns. The greed and the certainty that more jackpots will be hit lead most to ruin, just like in casinos, the house wins most the time. That’s how casinos stay in business after all.

So, you’re not the reckless kind and you’ve got a plan. Buy a few hundred $ each month in varied cryptos, aiming for the long run. This is a sensible strategy. Those who started investing in cryptos month by month in 2010 own a fortune today. In fact if you had bought just $100 in Bitcoin since the early days, you’d be a billionaire today. Bitcoin has been the single greatest growth investment in the history of finance. Not even Apple or Amazon stock can compare to what Bitcoin has achieved in the past 9 years. As with good stocks, it pays off to buy a little Bitcoin each month and just hold.

Your first decision is, therefore, to decide why you wish to invest in cryptocurrencies. The most sensible strategy so far has been growth investing, to deposit a bit each month and forget about it. In 10 to 20 years the odds are in your favor using this sort of strategy, but prepare for a good ride, some months Bitcoin will go up 200%, others will go down 60% –  that’s how crypto investing works.

Risks Involved

Several different risk profiles can be built around cryptocurrency investing. Risk management is complicated when it comes to something as volatile and, let’s face it, as crazy as the crypto world. Investors really should not attain themselves with nitty gritty details when it comes to cryptocurrency risk. In fact, the soundest strategy when it comes to cryptos is to just buy and forget about it. Minding every single dip and every single spike is a recipe for stress and low quality of life. If you plan on watching candlesticks live, be prepared for sleepless nights, low quality of life, family relations degradation and all that comes with a manic market that is open 24×7, 365 days a year.

Crypto markets do not close. That’s one big issue for compulsive investors: you’ll end up sleeping on top of your notebook PC more often than your doctor recommends.

Regulation is one source of risk in crypto. China announces some new rule and the price of cryptos can swing 100% easily. South Korea announces investigation into some ICOs and the prices collapse. The USA has a Congress hearing about cryptos and prices go crazy with every tough question and answer. The SEC puts out some new regulation and prices go berzerk. It’s a crazy world out there in crypto trading and regulation is one of the major risks involved.

In one extreme there exists the possibility that all crypto could be banned in one fell swoop. The US or Europe could down a new load of regulations that could make taxing, accounting or banking impossible for cryptos. Such a radical move is improbable, but possible. Any risk model should include “complete ban” as a low probability yet high impact event.

On the other extreme, there is the possibility that major economies embrace cryptos and let them flow freely, without the expected interventionism. Such complete freedom is improbable, as taxation is in the crosshairs of most governments. No major economy would give up on taxing cryptos and in order to tax them you need proper regulations. You can’t tax an informal economy.

Legal Aspecs

So, while regulation doesn’t come, or comes in parts and in often confusing ways in different countries, there are many conflicting regulations in place. ICOs are heavily regulated in the US, but cryptos really are not heavily regulated in America. In fact, Bittrex, Coinbase and others operate with relative freedom in the USA. What we’ve seen so far is the IRS is very much interested in Coinbase and exchanges, as they should be, since, as we mentioned, taxation is not going away for cryptos. Given the thousands of % profit obtained by long term crypto investors, they shouldn’t mind paying a few percent tax anyway. The returns for those who invested in Bitcoin early on are on the order of tens of thousands of percentage points. Who cares about 15% tax?

Then there’s international issues. If you invest in the Venezuelan sovereign crypto fund, you may be held liable under US sanctions placed on that country. International law is complicated and most crypto investors have no access to a qualified, and expensive, international law attorney. In fact, 99% of crypto speculators are young, relatively broke and more idealistic than anything else. Cryptos are inherently international, they’re not based anywhere but are peer to peer, how do you regulate the massive P2P trade going on every minute? The fact is nation states will face immense challenges taxing and regulating cryptos. We may speculate that a large percentage of crypto profits will never be declared to any tax authority anywhere. Unless cryptos are converted back to fiat money, there is simply no way they can be taxed. This is a complicator and as exchanges become more and more decentralized and P2P this will only become a bigger and bigger problem for governments. Completely encrypted P2P crypto exchange is probably impossible to tax. And that which is impossible to tax will be subject to prohibition for sure. There are very interesting times ahead for decentralized crypto trade.

Choosing Cryptos

So you’ve decided to take the plunge and invest. You’re well aware of the risks, the regulations and everything else and you want a piece of the crypto pie. Great! Welcome aboard.

Now it’s time for the most difficult part: choosing the right crypto assets to invest in. At the time of this writing (mid 2018), there are over 1500 cryptocurrencies listed on CoinMarketCap.com. Some of these may rise from the 5th page to the first, and those who invest in them will reap amazing rewards. Others will slip from page one of CoinMarketCap and into oblivion. How to choose the right investment? What’s the next Ethereum?! If only we, or anyone else, knew.

There are ambitious projects out there. Cardano ADA wants to be THE 3rd generation cryptocurrency. It is being designed with several layers on top of the raw blockchain already planned from the beginning, but much more. Cardano wants to be compliant and transparent, so that regulators will fall in love with it. They want to be formally verified, which is a technique in software that promotes very secure and reliable software. Projects like Cardano light up the investors panels with potential. But there are also risks. What if the software is never formally verified? What if the staking protocol isn’t wall it’s expected to be. Bitcoin is where it is today after 9 years of testing, after being under heavy attacks and consistently rising above difficulties. During November 2017, Bitcoin was under heavy attack, many proclaimed it was the flippening. Bitcoin Cash would invert positions with Bitcoin, it’d be the #1 coin and Bitcoin would become history. All of a sudden Bitcoin’s immune system kicked in, the network difficulty fell, it became more profitable to mine and suddenly thousands of miners came back to Bitcoin. All this happened automatically, it was Bitcoin’s difficulty algorithm working all by itself in decentralized fashion. In the early hours after the difficulty adjustment Bitcoin was back to normal and in full steam.

Cryptocurrencies, therefore, must be tested in the real world. Choosing a crypto that is reliable requires investors to look at its development history. A lot of people lost money investing in Dogecoin, since its development team all but abandoned the source code repository. Sometimes there are years between updates to the Dogecoin github repo. Remember when Dogecoin was the #3 cryptocurrency in 2014? Good times! Well, it hasn’t performed as well during the past 4 years. This is not meant to single out DOGE. It’s a great, fun and exciting project with a very charismatic community around it. But it’s a good example of how the development team must be fully integrated with the cryptocurrency business in order for it to flourish. We see daily commentary and involvement by Vitalk Buterin, he’s involved, engaged and wants Ethereum to succeed. This is the mark of a good cryptocurrency, when its technical leaders are active within the community.

But choosing a crypto solely through its community isn’t guaranteed success. Folks who invested in Bitcoin in late 2017 were attracted by arguably the most exciting community in cryptocurrency, and until now they have not realized a single penny in profit. Dogecoin is another example of a great and friendly community, but whose crypto market performance hasn’t been stellar, for many reasons, among which are the development team we’ve mentioned before.

Litecoin is a historic alternative to Bitcoin. Back in the early days the top 3 cryptos were Bitcoin, Litecoin and Dogecoin. Litecoin held onto 2nd place for a very long time, until Ethereum came about a few years ago. Then came EOS, Ripple and Bitcoin Cash which overtook Litecoin in market value. Each of these cryptos has a unique proposition. Ripple is a centralized bank-sponsored crypto which aims to become the defacto inter-banking protocol for the future. Bitcoin Cash aims to become Bitcoin. And so on. Perform due diligence before diving into any of these cryptos. Make sure you believe in their long term goals and in their management. Pay special attention to the development teams, in the end developers will have the final word. It is important for the development team to be active, transparent and community driven. The Bitcoin Core developers are a great example of such a well balanced team with community priorities in first place.

Centralized and Decentralized Exchanges

Lastly you need to decide on how to begin trading cryptocurrencies. Centralized exchanges will likely be your first choice. Coinbase, Bittrex, Bitfinex, Bitmex and you name it, there are countless exchanges where you can begin to trade immediately. We recommend that you choose a few good exchanges and perform their ID checks in order to keep your account safe and unlocked at all times. Use proper 2FA authentication, and send them your documents so that you can be considered a level 2 or higher account. Level 1 accounts are attractive initially, but they are subject to higher scrutiny and even to blocks sometimes. If your trading raises any warnings within the exchange system, and you’re not identified, chances are your account will be locked. Since cryptos are deregulated, there really isn’t much you can do if your account is locked for a very long time. We’ve seen traders get their account locked for months without having done anything specifically bad. It was a security system warning that triggered an automated review, and in the meantime the investor cannot move their funds. It is therefore ideal if you are fully identified and verified with your exchange of choice, that way the odds of being locked out are minimized.

Decentralized exchanges offer many novel advantages but they really aren’t ready for prime time yet. There is significant lag between the time the bids and offers are posted and the time they reach some of the interested parties. This results in stale bids and offers which suddenly disappear just as you become ready to hit them with your order. There is little doubt that decentralized exchanges will be in your future trading routine, but for beginners we recommend to start getting used to trading using traditional centralized exchanges.

We hope this random walk through crypto investing has helped you get a clearer view of the fascinating yet complex world of cryptocurrency investing. There are unlimited choices, nearly infinite combinations between cryptos and fiat currencies and you must take a very disciplined and careful approach in order to make money trading cryptos. It is not easy to maintain a constant winning record. Sometimes there are great losses in cryptos and sometimes you hit homeruns that make it all worth it. A lot of people made great wealth investing in cryptos, but they did so by investing early and by holding on. High frequency traders rarely maintain higher than average returns, in fact very good fund managers come out even after an average of 7 years. Remember this when speculating : great fund managers maintain value, bad ones lose it all. The safest investment strategy in crypto is to buy a little every month and hold on, this tends to average out in the long run and significant returns may be obtained by simply leveraging the fact that Bitcoin is limited to 21 million coins and they will become rarer and rarer with each halving. Good luck!


Graph illustration credit: David Benbennick via Wikipedia

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