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, what are cryptocurrencies, how to trade them, 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.
After looking at what are cryptocurrencies, let’s look at how to trade them.
How to Trade Cryptocurrency
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 Crypto 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.
- Scalping: Scalping is a strategy that involves buying and selling a cryptocurrency quickly in order to profit from small price movements. This strategy typically involves making many trades over the course of a single day and requires the trader to have a strong understanding of market trends and to be able to act quickly to take advantage of price movements.
- Trend trading: Trend trading is a strategy that involves following the overall direction of the market and buying and selling a cryptocurrency based on whether the price is trending upwards or downwards. This strategy may involve using technical analysis tools, such as moving averages and chart patterns, to identify trends and make trading decisions.
- Momentum trading: Momentum trading is a strategy that involves buying a cryptocurrency that is showing strong price momentum and selling it when the momentum slows down. This strategy often involves using indicators, such as the relative strength index (RSI), to identify overbought and oversold conditions and make trading decisions accordingly.
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 cryptocurrencies.
What is the Best Cryptocurrency to Day Trade?
It is difficult to determine what are the best cryptocurrencies for day trading, as the most suitable cryptocurrency for day trading will depend on the individual trader’s risk tolerance, market knowledge, and investment goals. Some factors to consider when choosing a cryptocurrency to day trade include:
- Volatility: Day traders typically seek out cryptocurrencies with high levels of volatility, as these can provide more opportunities for profits. However, it is important to keep in mind that high volatility can also increase risk, and it is important to have a well-thought-out trading plan in place to manage this risk.
- Liquidity: It is important to choose a cryptocurrency that is highly liquid, meaning that it is easy to buy and sell and there is a large volume of trades taking place. This can help ensure that the trader is able to enter and exit trades quickly and at a reasonable price.
- Market depth: A cryptocurrency with a deep market depth, meaning that there are a large number of buy and sell orders available, can be more suitable for day trading as it can provide more opportunities for profits.
- Regulatory environment: The regulatory environment in which a cryptocurrency is traded can impact its suitability for day trading. For example, cryptocurrencies that are traded on regulated exchanges may be more stable and less prone to manipulation than those that are traded on less-regulated exchanges.
It is important to thoroughly research any cryptocurrency before day trading it and to have a clear understanding of the risks involved.
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 exchanges 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.
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.