Cryptocurrencies have become very popular among active traders with their high volatility, low transaction costs and always-open markets. If you’re interested in trading cryptocurrencies, it’s important to take the time to understand the asset, build the proper trading strategy and ensure that you’re keeping track of your transactions for tax reporting purposes.
Let’s take a closer look at the asset class, how to trade cryptocurrencies, popular trading strategies and how you can keep everything in order for tax time.
What Are Cryptocurrencies?
Cryptocurrencies are globally fungible commodities with low transaction costs, near-zero transportation costs and low-to-zero storage costs, according to Bitwise. These attributes mean that cryptocurrencies are uniquely suited for both long-term investors as an alternative asset and short-term day traders given the tight spreads and low transaction costs.
Under the hood, cryptocurrencies are essentially an immutable ledger of transactions stored on a decentralized peer-to-peer network. Cryptography algorithms make it impossible for anyone to tamper with the ledger; the decentralized network means that no government or individual has direct control; and, the electronic nature of the market translates to low friction.
Cryptocurrencies are often bought and sold through exchanges, such as Coinbase. Through these exchanges, you can buy, sell and exchange a wide variety of cryptocurrencies at established exchange rates. You can also hold cryptocurrencies in online or offline wallets, but if the wallet is lost or inaccessible, it’s impossible to recover the cryptocurrency.
How to Trade Cryptocurrencies
Day traders are attracted to cryptocurrencies because of the low commissions, always-open markets and fewer regulations compared to stocks and futures. For example, Bitwise found that Coinbase Pro had a spread of just $0.01 on Bitcoin, which translates to a 0.0003% spread — one of the tightest quoted spreads of any financial instrument in the world!
The most popular exchanges for cryptocurrency traders include:
Cryptocurrency trading is more similar to foreign exchange (forex) trading than stocks or futures. Rather than always transacting in U.S. dollars, traders have access to many different cryptocurrency pairs. For example, you can buy Bitcoin with Ethereum to simultaneously go long on Bitcoin and go short on Ethereum without ever touching U.S. dollars.
In addition to trading cryptocurrency pairs, cryptocurrency traders may participate in initial coin offerings, or ICOs. ICOs are similar to initial public offerings, or IPOs, in that they are designed to fund new blockchain-related projects. The newly minted tokens that come as a result of an ICO are similar to a newly IPO’d stock.
Common Trading Strategies
Most cryptocurrency trading strategies mirror those of traditional capital assets. For example, active traders may use technical analysis to identify potential entry and exit points for a given cryptocurrency pair. Traders betting on an ICO may take a position early on to capitalize on the potential gains for the newly minted token in the same way they buy an IPO.
Some of the most common trading strategies include:
- Moving Average Crossovers: Moving averages are created by taking the average price over a specified period of time and applying it to the current price chart. A common trading strategy is to watch a long- and short-term moving average for crossovers. For example, a 50-day moving average crossing above a 200-day moving average could be a buying signal.
- Breakouts & Breakdowns: Many traders draw lines between the peaks and troughs of a price chart to create so-called trend lines. The more times the price reacts to these trend lines the stronger the trend line becomes. If the price breaks out or breaks down from a trend line, traders may take a long or short position in the cryptocurrency.
- Chart Patterns: Many traders look at chart patterns designed to assess the underlying psychology of the market. For example, an ascending triangle pattern may suggest that the price is gearing up to break out higher. Candlestick patterns can also be used to assess market sentiment at specific points in time to find entry and exit points.
Cryptocurrencies are unique compared to many other assets, such as currencies, stocks or futures, because they are not impacted by many fundamental factors, such as earnings reports, interest rates or economic reports. However, traders must be aware of some important changes that take place over time, such as hard forks or other changes to the structure of the cryptocurrencies.
Tracking Your Trades for Taxes
Cryptocurrencies may have “currency” in their name, but the IRS has made it clear that they are to be treated as property. This means that traders are responsible for tracking every transaction and reporting each gain and loss. These figures are reported on Form 8949 and Form 1040 Schedule D at tax time alongside stocks and other capital assets.
The challenge with cryptocurrencies is establishing a cost basis. For example, suppose that you buy Bitcoin with Ethereum on a specific date. You may know the exchange rate between these transactions, but you must also calculate the cost basis in U.S. dollars to determine the profit or loss. This means that you must know the U.S. dollar exchange rate for each.
The good news is that many exchanges have simplified the reporting process for taxes. You can easily export a list of transactions and automatically compute the cost basis. The bad news is that you must merge these figures from multiple exchanges and wallets, and then you must still accurately fill out the proper tax forms with the aggregate.
ZenLedger makes it easy to import cryptocurrency transactions from multiple exchange and wallets, calculate gains and income, and autofill tax forms like Form 8949 and Form 1040 Schedule D. You don’t have to worry about accurate differentiating between short- and long-term capital gains or consolidating information from multiple sources.
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The Bottom Line
Cryptocurrency trading has become very popular over the past several years given the high volatility, low transaction costs and always-open markets. However, it’s important for traders to take the time to understand these assets, how to best trade them and how to keep everything organized for tax time.