Before an investor trades bitcoin, they should be sure to review the basics. By doing so, they can increase their chances of meeting their investment objectives, whether they want to generate robust returns or simply use bitcoin to diversify their portfolio.
Why Trade Bitcoin?
For starters, investors may want to first consider why they would want to trade bitcoin. After all, many market observers have stated that the digital currencies come with substantial risk. For example, European Union regulators warned in early 2018 that cryptocurrencies are "highly risky."
Legendary investor Warren Buffett has repeatedly warned investors about digital currencies, telling CNBC in 2018 that "in terms of cryptocurrencies, generally, I can say with almost certainty that they will come to a bad ending."
While some have warned about bitcoin's risky nature, the digital currency has experienced some very impressive gains. In 2017, for example, Bitcoin's price rose from less than US$1,000 to more than US$20,000.
Bitcoin's price has also frequently moved out of sync with the price of other digital assets, making it a prime candidate for diversification strategies. Because the digital currency's price movements do not follow those of other asset classes, incorporating it into a portfolio can help maintain greater stability.
Investing vs. Trading
Once an individual has evaluated whether bitcoin is right for them, they can begin looking into whether it makes more sense to invest in the digital currency or trade it. While these two may sound the same, they are different.
When differentiating the two, the easiest way to think of it is that investing is a long-term activity, and trading is a more short-term activity. For example, many people invest for retirement, accumulating wealth over time so that they can build up a viable nest egg. Alternatively, they may save up for their children's college education.
Trading can be far more short-term, however, as a person could purchase a security with the intention of selling it later the same day. High-frequency trading, a more extreme example, involves buying and selling assets within fractions of a second.
Investors should keep in mind that bitcoin is notoriously volatile. It's price has experienced both sharp rallies and notable declines. As a result, these investors should remember that they could potentially lose the value of their principal rather quickly by trading bitcoin. On the other hand, they could potentially generate some very compelling returns by trading this digital currency.
Do Your Own Research
This one may sound like a given, but it is particularly important for traders considering a highly volatile asset like bitcoin. The digital currency is a very new asset relative to many other securities.
While stocks and bonds have been around for some time, the first bitcoins were produced in 2009. At the time of this writing (March 2018), the digital currency has been around for less than a decade, making it rather new compared to more established assets.
There are plenty of cryptocurrency scams out there, too. Many initial coin offerings (ICOs) have been taking place in the digital currency space, and these sales of newly created digital tokens have provoked warnings from prominent market experts such as ether co-founder Vitalik Buterin.
Further, the regulatory environment surrounding digital currencies is very immature, meaning that varying government agencies and other entities have provided disparate guidance. The Commodity Futures Trading Commission (CFTC) in the U.S., for example, declared in 2015 that bitcoin was a commodity like gold or oil. As a result, the CFTC has the authority to regulate the digital currency.
The U.S. Securities and Exchange Commission has also provided guidance on digital currencies, indicating in 2017 that the digital tokens sold through ICOs could in some cases be securities. In the instances where these tokens are securities, they are subject to U.S. federal securities law.
However, the developments involving the CFTC and SEC only speak to U.S. regulations. When examined through a global lens, digital currency regulation can become even more confusing.
Cryptocurrencies were a major topic of discussion at the 2018 G20 event in Argentina, where representatives of major economies reportedly worked toward a consensus that bitcoin—and other digital tokens—are in fact assets.
"Whether you call it crypto assets, crypto tokens—definitely not cryptocurrencies—let that be clear a message as far as I'm concerned," stated Klaas Knot, who heads De Nederlandsche Bank, the central bank of the Netherlands. "I don't think any of these cryptos satisfy the three roles money plays in an economy."
Given these considerations, it is even more important for would-be bitcoin traders to conduct their due diligence before getting involved with the digital currency.
There are many places that investors could start when researching bitcoin. They may benefit from scouring industry terminology, learning terms like HODL (hold on for dear life), FUD (fear, uncertainty and doubt) and shill (a person who promotes coins they own in order to turn a profit).
In addition to determining whether bitcoin is right for them, investors should evaluate how the digital currency fits in with their financial objectives and any existing portfolio they have. Bitcoin traders may also want to familiarise themselves with the broader cryptocurrency ecosystem by learning about the prominent personalities and their unique voices.
Learn Bitcoin's Price Drivers
In order to trade bitcoin effectively, investors should be familiar with the major variables that help determine the digital currency's price.
At the most basic level, bitcoin's price is a function of supply and demand. The total supply of this digital currency is capped at 21 million, which means only 21 million total units of bitcoin can exist at any time, according to current rules.
At the time of this writing, 16.9 million of these digital tokens have been mined. These units are created through the process of mining, which involves processing transactions in to a "block" in bitcoin's blockchain.
Every time a block is mined, a "mining reward" is provided. This reward gradually declines over time. While mining the first block released 50 units of bitcoin (BTC), the mining reward has been cut in half (halved) approximately every four years. At the time of this writing, the mining reward was 12.5 BTC.
While these figures might prove helpful, it is worth keeping in mind that the information needed for many bitcoins has been lost. Nicholas Gregory, CEO of blockchain infrastructure company CommerceBlock said in late 2017, "There's probably two or three million bitcoin that will probably never be used. There's quite a lot that have been lost."
While the aforementioned information covers the supply side, the demand side must also be explored in order to provide a full explanation.
Some market analysts believe that bitcoin's price is largely a function of market sentiment, which could also be referred to as "animal spirits," a term coined by legendary economist John Maynard Keynes to explain the emotional approaches that many investors take to decision making.
There is evidence to support the belief that media coverage is a major driver of bitcoin's price movements, too. The digital currency's price has experienced sharp increases during times when it was covered by the mainstream media.
This development can result in bitcoin following what is known as a hype cycle. Basically, widespread media coverage can cause the hype surrounding a technology (like a digital currency) to peak temporarily before eventually falling to a substantially lower level.
Bitcoin has already experienced several cycles where it underwent sharp price appreciation followed by notable losses. While it is difficult to attribute its price movements to a single variable, the digital currency suffered substantial volatility as it drew mainstream media coverage.
Another major factor that analysts have often cited as driving bitcoin's price movements is macroeconomic and/or geopolitical turmoil. Analysts have repeatedly described bitcoin as a safe-haven asset.
Chris Burniske, a prominent analyst who worked for investment manager ARK Invest, told CNBC that bitcoin could be referred to as "digital gold," stating that the cryptocurrency has many of the same qualities as the precious metal.
"When you look at the global markets, there's lots of fear, uncertainty and doubts," Burniske said. Investors have frequently flocked to safe-haven assets like gold during times of market turmoil.
Another major variable is regulatory developments. As stated earlier, the regulatory framework surrounding digital currencies is very immature, meaning it could change quite a bit over time. Digital currency exchanges have sometimes found that in order to attract institutional investors, they must proactively develop robust compliance in order to stay in accordance with regulations.
Select An Exchange
Finding the right exchange is a crucial step for a new bitcoin trader. Many digital currency exchanges have been hacked, including Bitfinex, which has at times been described as the world's largest bitcoin exchange.
Bitfinex suffered a hack during the summer of 2016, during which it lost roughly US$70 million worth of bitcoin. The exchange survived the experience, spreading the losses it suffered across all accounts and compensating account holders with newly created digital tokens, which it in turn bought back.
While Bitfinex managed to pull through a hack unscathed, Tokyo-based exchange Mt. Gox was also compromised by nefarious parties, which resulted in the loss of US$460 million. Mt. Gox went into bankruptcy, and a trustee named Nobuaki Kobayashi started selling digital currencies on behalf of creditors in March 2018.
Investors can benefit substantially from conducting their due diligence on any exchanges before using them. There is a short list of digital currency exchanges that have not been hacked at the time of this writing. For instance, Coinbase has never been hacked. However, its customers have been hacked after falling victim to elaborate schemes.
Basic Security Techniques
In addition to picking out the right exchanges, investors can reduce their chances of getting hacked by learning more about security techniques.
One of the most basic techniques is two-factor authentication, which requires users to take more than one step to confirm their identity. Not all forms of two-factor authentication are created equal, though. Using Google Authenticator instead of SMS, for example, can make a big difference.
If investors want to use Google Authenticator for two-factor authentication, they should be sure to turn off their SMS two-factor authentication, according to Dan Romero, vice president and general manager of Coinbase.
Another way investors can prevent their money from getting hacked is contacting their cellular service provider and taking every effort to protect their account, said Sean Everett, Coinbase's VP of product management. Traders can request that their mobile service provider refrain from porting any phone numbers, which adds another layer of protection.
Would-be bitcoin traders should keep in mind that while they can potentially generate substantial gains through digital currency, there are many different factors they should consider before making trades. Failure to conduct thorough due diligence could mean losing all of one's money.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…