Tue. Aug 20th, 2019

Five rules to master before trading crypto

The basics of trading do not have to be complicated. Anyone can learn to trade and invest money smartly

However, there is a tendency to overlook the basics and this often results in building the wrong type of foundation.

If you see trading and investing as a means to make fast money then all you are doing is applying a gambling mindset to a game of skill.

Put another way, if you do not know what the pawns on a chess board represent, then how are you supposed to play a proper game? How would you be able to develop a strategy to win if the rules of the game are unclear to you?

The same principle applies to cryptocurrency trading and investing. And the same reasoning is applicable to trading and investing other financial assets also.

So without further ado, let’s proceed with the five essential rules you must master before you start your online trading and investing journey.

1. Understand what you are buying, and what’s driving its value

Can you answer what a utility token is and how it derives its value? If you can, then you are already on a great path.

Educating yourself about the assets you are about to expose yourself to is crucial because without that knowledge you will not be able to assess the risks.

Start by ask yourself, what am I really buying?

Let’s break it down and start by identifying some of the key differences between traditional financial markets and the cryptocurrency markets.

I will then break the question down to a point where we can make some interesting observations about:

  • the type of financial instrument utility tokens resemble;
  • how cryptocurrencies could be valued;
  • what’s currently driving the price of cryptocurrencies;
  • what may become a more important driver of cryptocurrency valuation in future.

BACK TO BASICS: SOME OF THE KEY DIFFERENCES BETWEEN CRYPTO AND TRADITIONAL FINANCIAL ASSETS

Fundamentals

In traditional financial markets (such as shares and forex) you can base your investing or trading decisions on fundamentals.

So when you buy a share you can check the company’s financial statements to understand the health of that particular company.

Similarly, if you are are trading forex, then you would analyse economic data to understand how interest rate differentials between two countries will move in the months ahead, and so on. 

But cryptocurrencies are a different animal altogether.  

Cryptocurrencies have fewer fundamental drivers and are almost purely driven by behavioural factors, which will be discussed in more detail below. 

Liquidity and volatility 

Furthermore, the cryptocurrency market (relative to forex and the equities market in general) is less liquid.

This explains why crypto assets are so much more volatile than traditional financial market assets.  

But it is precisely the high level of volatility that makes bitcoin and other cryptocurrencies attractive to traders. At the same time, there is an underlying mega trend that makes this particular asset class attractive to long-term investors as well. 

Historical benchmarks, mechanisms and mature regulation 

Traditional financial markets have been around for a very long time so there are established benchmarks, mechanisms and regulations in place to protect people. 

However, since cryptocurrencies are relatively new there is hardly any regulatory oversight, at least for the time being. This explains why the cryptocurrency market has been highly susceptible to market manipulation and scams. 

And even if you do everything right and have made a lot of money on crypto, you could lose your entire crypto wealth in an instant through a hack or through human error.  

Now that we have identified some of the key differences between cryptocurrency markets and traditional financial markets,  let’s take it a step further to address the following question properly. 

WHAT ARE UTILITY TOKENS AND WHAT IS DRIVING THEIR VALUE?

Do you know what you’re getting when you expose yourself to a utility tokens? 

It is easier to start by explaining what they are not.

You are not buying a participation right in the underlying operation of a business. A utility token is not equity or a share. 

Utility tokens resemble financial options

CoinMarketExpert defines a utility token as a right, but not the obligation, for its holder to participate in a future exchange of value (in the form of a service). 

This is in fact the definition of a financial derivative, more specifically an instrument called an option.

When you buy a utility token there is an expectation the money a company is raising will be invested into the operation to create a service that will one day become useful to you.

The idea here is that you will eventually derive value from the token by exchanging it with a free service or a discount on a service.

Utility tokens can be valued as an option

Now that we have understood that a utility token, in its current shape and form, resembles a financial option we could apply option pricing models to value them.

Options, just as utility tokens, are also extremely volatile and risky and Black-Scholes is a popular pricing model that is used to establish the fair price of a call or a put option.

You need six inputs to run a Black-Scholes model: volatility, type of option, underlying stock price, time, strike price, and the risk-free rate. But whilst an option pricing model such as Black-Scholes could be helpful in providing an indicative token valuation, the reality is there are currently no reliable inputs. It is not a straight forward apples for apples comparison.

The majority of crypto operations do not have any audited historical financial records or established benchmarks. Furthermore, the underlying technologies are not mainstream yet.

Technical Analysis remains a major driver

In the absence of any reliable fundamental data, the crypto market is almost purely driven by behavioural finance.

Behavioural finance looks at a combination of sentiment and trend analysis, and is captured by Technical Analysis.

Share trading, especially forex trading, also rely on technical analysis although the fundamental driving forces are more important. 

Fundamentals vs Technicals

Traditional financial market assets are mostly driven by fundamental factors although technical analysis is often used in conjunction to determine entry and exit points.

As a generalisation I would say that traditional financial market assets are 80% driven by how the market expects fundamentals to change in future and 20% by technical analysis. 

With cryptocurrencies it seems to be the other way around. 80% is driven by technical analysis and 20% by factors that are deemed to be fundamental.  

What are the fundamental drivers of crypto?

There are not many. 

Price and circulation supply are the most common fundamentals. 

You could also analyse how changes to the underlying cryptocurrency algorithm will affect price and supply too. That is why so many people make a fuss about the halving of block rewards. You may want to read a separate post on litecoin and bitcoin halving, here.

Qualitative factors also drive fundamentals

But there are also many common sense qualitative factors to look for. 

You will want to do research on the underlying operation to understand whether the client base is growing and whether talent is being recruited.

Check out websites such as Glassdoor to see whether employees are leaving positive feedback about their employer as well as the general sentiment on Telegram channels and social media. 

If the underlying operation is brand new and has not reached monetisation yet, the first thing you want to do is check the founder’s profiles on LinkedIn to see if they have any credible experience.

Also look at whether the operation has received any funding from reputable investors and whether a trustworthy board of directors has been put into place.  You could find this information on Crunchbase.

All these qualitative factors matter even though a utility token does not represent an equity stake in a company. This is because the value of a token is absolutely worthless if there is no operation in a year or two. 

The token is only valuable to you if the operation still exits and the company is able to provide you with a service in exchange for your token. 

The great convergence

CoinMarketExpert believes there will be greater convergence between crypto and traditional financial markets in future. This may help to create a stronger fundamental base for cryptocurrencies.

For example, when securitisation becomes more mainstream, certain companies may decide to securitise their utility tokens so that loyal early adopters could eventually obtain an equity stake in the operation. 

So although Technical Analysis is an important tool to learn at this juncture, it will increasingly become useful for you to take a longer-term view on the cryptocurrency market and start to learn how traditional financial markets also function. This means becoming familiar with how forex markets work and how companies are valued.

Learning how traditional financial markets work will be helpful to you in the long run as you may consider increasing asset diversity in your portfolio, which I will discuss in more detail below.  

CoinMarketExpert envisages the convergence process to accelerate when token securitisation moves into the spotlight and as soon as cryptocurrency and blockchain regulation starts to take more shape, especially in the major developed countries.

The good news is CoinMarketExpert will be here to guide you at every step.

2. Understand whether you are a trader or an investor

The psychology is critical. Understanding the risks and your own risk tolerance is crucial. 

Are you day trader? or an investor? are you simply buying for fear of missing out ‘FOMO’? 

This section will cover the following:

  • the difference between being a trader and an investor;
  • the benefit of experimentation (safely);
  • where to experiment such as online trading platforms as well as crypto exchanges and wallets;
  • You will also be introduced to the concept of leverage since certain online trading platforms provide margin trading on crypto.

Trader vs Investor

Cryptocurrencies are attractive to both traders and investors. 

Day traders are interested in the high volatility of cryptocurrencies whereas investors will be taking a long-term view that bitcoin or other cryptocurrencies will continue to rise in value over time, despite the volatility and occasional sharp corrections, as they become more mainstream.

Be honest with yourself because if you are buying to hold for the long term and the price of the cryptocurrency you just bought dips by 20%, you may very well start to panic and become inclined to sell at a loss (although you initially thought you were in for the long term).

The worst thing you can do is not genuinely understand your own motives. If you are unable to understand what you want then how could you possibly develop an effective strategy?

Experiment (safely)

It is fine to not know whether you are trader or an investor at heart initially.

Perhaps you are unsure about your trading or investment style? or perhaps you simply want to get a feel for both. Give it a try and find out.

Experiment with little money you can afford to lose or open a demo account with fake money to practice

To really understand what you are good at, you need to try new things and don’t be afraid to experiment (with small amounts that you can easily afford to lose.)

You may also want to consider opening a free demo account (with fake money) using a popular trading platform that offers cryptocurrency trading.

Free demo accounts often do not replicate the same experience as live trading.

Whilst free demo accounts are usually a good starting point to practice trading, the terms and conditions often differ from live trading accounts.

This means you will be practicing in fake conditions and will most likely not learn how to manage your risks when you do decide to move onto a live trading account. 

Online brokerage (with leverage) vs exchange and wallet (no leverage).

Trading assets, including cryptocurrencies, on an online trading platform will involve leverage.

This means the potential gains you could make are magnified by 10, 100, or even 1000 times. Conversely, you could also make losses that materially exceed your initial investment! 

What is leverage or margin trading?

The easiest way to explain leverage or margin trading to someone who is not familiar with the concept is to compare it to taking out a mortgage on a home.

Of course there is a material difference between a bank and an online brokerage platform offering margin. For example, if the price of the home drops below the value of the deposit, the bank would not give you a margin call and ask you to make up for the shortfall or even worse automatically sell your property and demand you repay everything back immediately including any shortfall – at least not any bank that I know of. This is in fact how online trading platforms that allow you to trade on margin or leverage tend to operate.

Let’s say for simplicity, the deposit margin for bitcoin is 10%. This means that if bitcoin is trading at $12,000 the online trading platform would request you deposit at least $1,200.  This may seem like a great deal since you could obtain the exposure of an entire bitcoin by only depositing a fraction of its current market value. But what you must understand is that potential gains and losses are significantly magnified, which also means you could end up losing significantly more than your initial deposit of $1,200. 

Therefore, trading with leverage is extremely risky and it is certainly not suitable for cryptocurrency newbies. After all, crypto is already very volatile and risky. Why exacerbate the risks for yourself?

When you buy or trade cryptocurrency through an exchange or a wallet it is generally without any leverage. This does not mean that your capital is not at risk. You could still lose all your money without using leverage except you will typically not end up owing more than your investment.

I know there are certain crypto exchanges experimenting with derivatives and leverage at the moment, although to my understanding these instruments will be specifically targeted at professionals.

But in the meantime, be patient and do not be afraid to experiment (with amounts you can easily afford to lose). Over time you will improve your understanding of markets and be able to identify where your strengths reside

3. Educate yourself about the markets & keep a diary to develop your skill

Don’t feel as if you need to learn everything at once. Certain things will come naturally to you and when they do just focus on developing your strengths and making them even stronger – to the point that it becomes a unique strength.

One of the most brilliant forex traders I met in the city only focused his energy on understanding a few currency pairs. He was brilliant at trading EURUSD pairs although was not as effective trading other currencies.

Most Olympic athletes apply an 80/20 approach to their training; they dedicate 80% of their time to making their strengths stronger and the remaining 20% to improving weaknesses.

The following points will be covered in this section:

  • the importance of being up to date with the market and understanding how news and expectations influence different asset classes;
  • recording your trading or investment decisions, explaining why you are exposing yourself to certain positions as well as identifying the risks;
  • being reflective (post trading) and identifying what you could have done better;
  • educating yourself about different trading styles and strategies.

Read the market updates

Educate yourself about different markets and asset classes and then try to understand how news and market expectations affect valuations and price.

The market updates I write on the landing page will help you understand how information affects different asset classes.

Keep a trading diary

Write down your observations about the market and the different asset classes into trading diary or notebook. Also use your diary to write down your key investment or trading decisions, clearly mentioning why you are exposing yourself to particular positions.

There is no harm in writing ‘fomo’ as long as you also mention the risks you are taking and what you are doing to mitigate those risks.

Be consistently reflective

Be consistent. Review the decisions and the risks you documented on your notebook periodically (perhaps daily if you’re a day trader or quarterly if you’re investing).

Be reflective in your reviews and document what went wrong (we usually learn the most through our mistakes).

Try different trading styles and strategies

You don’t have to be a day trader.

Perhaps you will only trade when certain market conditions are present.

For example, you may decide to purchase a cryptocurrency before its block rewards halve and then sell after an x% gain? and this may be the only strategy you will ever pursue and focus on.

Alternatively, you may decide to  buy before a major fork, and so on… 

Do your research and experiment. But whatever you do always be structured and measured

CoinMarketExpert will be doing a lot of the heavy lifting for you so visit us periodically for updates.

4. Understand the risks and learn how to manage them

How you approach risk is critical. Being a good trader or investor is about building endurance and longevity, and you can only do that if you can learn how to withstand the hits.

The starting point for most professional traders and investors is to begin by evaluating the risks.

Generally speaking, if you cannot understand something, then you probably do not know how to measure it and that implies that you should not even be considering it – unless you are treating it as a gamble or an experiment – in which case, only deploy whatever you can afford to lose.

This section also aims to help you learn how to start taking a more measured approach to risks and will therefore cover the following points:

  • Getting into the habit of assessing the risks first before entering trades and investments;
  • Use limit orders to buy and sell cryptocurrency and become comfortable closing loss making positions as well as using of stop losses properly;
  • Hedging your trades and asset diversification benefits are critical for you to understand.

It is not just about the potential returns

Professional traders and investors often start by evaluating the potential risks and losses that could result if certain adverse scenarios pan out.  This is usually the first point of call before placing a trade or investing money.

And these professional traders will look at a number of different risk metrics to understand how volatile the asset they are going to be exposed to really is. These risk metrics involve understanding things such as price variance, standard deviation, value at risk, and so on. This subject will be discussed in a separate guide.

Learn how to use limit orders

Limit orders are extremely useful in reducing the risks of trading and investing, particularly when the underlying market or asset is extremely volatile.

For example, if you place a market order to buy bitcoin you may not obtain the price you intended due to the volatility in the price. However, limit orders will help you secure the price you want or even better when buying and selling. Learn how to use them.

If you place a buy limit orders’  it will allow you to buy at the price you want or even lower (which is better for you) and ‘sell limit orders‘ allow you to sell at the price you want or higher (which is also better for you).

Become comfortable closing loss making positions

Do not fall into the confirmation bias trap “if he or she said the same thing I was thinking, then I must be correct“. And sometimes you can become biased by reputable analysts reporting on the news, so the lesson here is to learn how to become very objective.

Never ‘fall in love’ with your positions and be prepared to cut your losses.

Professional traders in traditional financial markets often exit positions when the underlying price of an asset is between 15% to 20% in the red but this decision will very much depend on your circumstances and the type of strategy you choose to follow.

As a general rule of thumb, it is good practice to try and establish a stop loss rule for yourself, which brings me to the next point.

Learn how to use stop losses properly

Stop losses are useful because you can set them up to automatically close a position when a certain adverse price threshold is reached, thus limiting your losses.

Stop losses are absolutely critical to use when trading with leverage or margin. As mentioned earlier, when you trade on margin there is a risk of losing more than the amount deposited into the trading account. 

Learn how to place stop losses properly because if you place them too close to your entry level, you may risk being stopped out too soon. However, if you place your stop losses too far apart from your entry level, you may end up with substantial losses that you may not be able to pay back to the online broker. Tread carefully and learn how to manage your risk.

Are stop losses useful for investors as well?  

It is good practice to use stop losses even if you do not have any leverage. However, it also very much depends on your individual circumstances and investment strategy.

Generally investors are long term and know there will be bumps along the road and therefore I know investors (not traders) that do not use stop losses. However, their strategy does not involve any leverage and they have a thorough understanding of the risks they are taking. 

To mitigate their risk, these investors will purposely take small exposures in certain positions with an aim to build them up in a staggered manner over time or when certain market conditions present themselves. 

These conditions could be time based (buying or selling x% every month or every quarter) or they could be market based (buying or selling x% whenever the position dips 10% to 20%). However, we will discuss different investing and trading strategies in a separate guide.

Assess liquidity risk carefully

If the cryptocurrency asset you are trading has low liquidity then you risk being exposed to sharp and sudden price spikes (up or down).

As explained above, this is why it is particularly important for you learn how to use limit orders when buying and selling crypto as well as stop losses.

A lack of liquidity will cause sharp spikes to occur in the price so if you place your stop losses too tight around your entry level then you could quickly get stopped out at a loss, sometimes even at a significant loss due to slippage

Slippage occurs occurs when a stop loss closes the position at a different price, typically at a more adverse level than set in the order, due to high volatility.

You can reduce the risk of slippage by using ‘guaranteed stop losses‘ although not every broker or online trading platform offers them.

Learn how to hedge your exposure

Perhaps it is one of the reasons why so many retail traders end up racking up more losses than gains. It all boils down to risk management at the end of the day.   

So let me share some more wisdom with you. 

Whenever a professional trader takes a position, another position called a hedge is placed either simultaneously or a few seconds apart; so if a trader takes a position in the S&P 500 index they may also want to consider taking an exposure to gold as a hedge (think of hedging as an insurance).

For example, the S&P 500 fell nearly 6% between 1st August 2019 and 5th August 2019 as the trade war between the U.S. and China intensified. During the same period the price of gold rallied nearly 5%. So if a trader had taken a position in the S&P 500 and also gold over this period,  losses in their S&P 500 position would have been mitigated by gains in their gold position. 

Historically, gold has been a great hedge against intensifying geopolitical tensions. But it hasn’t always been a great asset to hedge the S&P 500 Index .

So the point I will emphasis here is that you have to strategically pick your hedges as they will only work when certain conditions present themselves.

The process of picking a hedge requires careful thought and there is no straight forward manual. 

Understanding these concepts will help you develop into a better trader and investor. But while we are on the topic of gold, let’s briefly discuss why bitcoin is considered to be ‘digital gold’ and whether it could be used as an appropriate hedge.

Why is bitcoin considered digital gold?

Bitcoin has been dubbed ‘digital gold’. Do you know why?

The reason why bitcoin has earned the title of ‘digital gold’ is because people living in developing countries that are going through extreme periods of economic and financial distress have been known to buy bitcoin in order to protect their wealth.  

During periods of severe economic and financial distress, certain developing countries may resort to capital controls, limiting the amount of money people can exchange to a foreign currency and transfer abroad.  So families living in these developing countries and who may have children studying abroad will have a serious problem maintaining them.

The solution to these issues has been bitcoin. This is the reason why bitcoin is perceived by many to be the best alternative to the precious metal and from this perspective a store of value.

As bitcoin becomes more mainstream, institutional financial market traders and investors may start to take positions in the digital currency to hedge against rising geopolitical tensions in developing countries or quite possibly to add some diversity to their portfolios. This brings me to the next point.

The benefits of asset diversification

Investors that have a portfolio composed of traditional financial assets may benefit from adding a small exposure to bitcoin to their overall holding.

But it works the other way around too. Holders of cryptocurrency should also consider adding traditional financial markets assets to their digital asset portfolios. 

Everyone involved in crypto should at the very least consider having some exposure to traditional financial assets to benefit from asset diversification.  

Diversification is never a bad idea.

Lack of regulation

The rising level of scams in the crypto market is for the most part attributable to lack of regulatory oversight.

The good news is this is changing, and regulation is evolving quite rapidly too. As the market becomes more regulated the number of scams stand to decrease.

Always try to pick the crypto exchanges and wallets that are working with regulators to become fully compliant and that take security measures extremely serious.

And if you are choosing an online trading platform that offers crypto, then ensure it has an established track record and that it is also regulated within a reputable jurisdiction.

The good thing about online trading platforms is that they are not as prone to hacking risks (when compared to crypto exchanges and wallets).  However, online trading platforms will very often not have a very wide range of cryptocurrencies for you to trade on.

Furthermore, remember that online trading platforms will expose you to leverage – so you really have to weigh everything up.

In my opinion beginners should stay away from leveraged cryptocurrency trading. Margin trading is something that is better suited for experienced traders.

As a matter of fact, the UK regulator, in its latest guidance on cryptoassets, has banned retail traders from exposing themselves to cryptocurrency derivatives citing a lack of knowledge and understanding of how to assess the value and risk.

If you want to learn more about the risks and how to keep your cryptocurrency safe, then I highly recommend you to read my guide on: ‘the risks of cryptocurrency‘.

5. Cryptocurrency trading is different from trading other assets

By now I hope this is evident to you.  

In general, I would say long-term investing and knowing how to save money is where you will make the biggest financial contribution for yourselves over the long run.

But cryptocurrency hits a sweet spot with me for the following reasons:

a) it allows traders to expose themselves to material price swings without necessarily using leverage. Traditional financial markets are less volatile than crypto and so traders often resort to margin trading to boost their returns. As explained earlier, the use of leverage means there is a risk losing much more than the initial investment. 

b) bitcoin and cryptocurrencies are a mega trend. They are becoming more mainstream, especially as regulation evolves. This will eventually encourage more institutional money to flow into the crypto space and may potentially be lucrative for those investors who are taking a long-term buy and hold view. 

c) there appears to be a more level playing field for bitcoin and cryptocurrency trading – at least for the time being. In traditional financial markets, professional traders that work for large investment banks have a material advantage over retail traders. This is because they have the backing of large financial resources to give them an edge in terms of data speed, knowledge and research.

Concluding remarks

CoinMarketExpert hopes you found this guide to be valuable.

Now that you have a good overview of what is required to build a great foundation in cryptocurrency trading and investing, you may want to read more about cryptocurrency taxation in your country to understand your tax obligations when purchasing cryptocurrencies.

If you enjoyed reading this page or have any valuable feedback to share then please do let us know. You may contact us on: info@coinmarketexpert.com

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