Cryptocurrencies have become popular among many different groups of people. Enthusiasts believe that it could eventually replace fiat currency, active traders are drawn to the volatility, and institutional investors are interested in the diversification benefits. While each strategy is different, there are some commonalities between them.
Let's take a look at three ways that you can make money with cryptocurrencies and how to decide on the right option.
#1. The Buy-and-Hold Investor
Many cryptocurrency enthusiasts believe that digital currencies could replace fiat currencies over the long-term, creating significant value for early adopters. For example, the combination of rising demand and a limited supply of Bitcoin could translate to rising prices over time. The million dollar question is if and when the transition will occur.
On the other hand, many alt coins aim to create value by building digital ecosystems. Ethereum's dApps are a perfect example of how cryptocurrencies could appreciate in value over time by becoming an important medium of exchange. The success of these cryptocurrencies depends largely on the platform's adoption rates and demand in the marketplace.
Buy-and-hold investors can make money by identifying and investing in the best long-term cryptocurrency opportunities — whether that's Bitcoin or alt coins.
The key to success is reading through white papers, researching team members and determining what projects are likely to succeed and what projects are doomed to fail.
#2. The Active Trader
There's no doubt that cryptocurrencies are volatile assets — it's not uncommon for them to rise or fall by double digit percentages in a given day or week. These dynamics make the digital currencies attractive to active traders that aim to capitalize on short-term price movements. For example, they may buy and sell a cryptocurrency within just a few hours.
Coinbase's Technical Analysis Platform - Source: Coinbase
Most active traders use technical analysis to analyze prices and find important trends. Technical indicators synthesize prices into understandable statistics to predict overbought or oversold levels, while chart patterns can help provide insight into underlying market psychology. The combination of these analyses can generate buy and sell signals.
Risk management is equally important to ensure long-term success. Rather than making big directional bets, many successful active traders focus on making small profits with minimal risk. They may develop and backtest a trading system with a projected win/loss rate and ensure that position sizes are optimized to prevent any significant drawdowns.
#3. The Diversified Investor
Cryptocurrencies are relatively uncorrelated with conventional financial assets, such as stocks or bonds, which makes them valuable on an institutional level. By improving the diversification of a portfolio, cryptocurrency assets can improve long-term risk-adjusted returns — even if they aren't always the best performing asset in the portfolio.
For example, an investor that held an all-stock portfolio between January 2008 and the market bottom in February 2009 would have lost about 50% of their capital. A diversified investor with 50% domestic stocks, 20% international stocks, and 25% bonds would have only lost 35%. More importantly, the two portfolios performed roughly the same by February 2014.
Investors looking to improve diversification may use conventional financial assets rather than purchasing cryptocurrencies directly. While there aren't any U.S. ETFs at the moment, international investors can purchase U.K. ETNs and U.S. investors can participate in the Bitcoin futures market, making it possible to diversify without owning cryptocurrency.
What Kind Are You?
There are many different ways to make money with cryptocurrency, but the right decision for you depends on your investment objectives and risk tolerance. For example, someone living on a fixed income in retirement with little disposable income should avoid risky speculation, but could benefit from added diversification for their portfolio.
It's also important to keep in mind that cryptocurrencies differ from other financial assets. In particular, most conventional financial assets generate cash flow over time. Cryptocurrencies should be thought of as an alternative to precious metals like gold, which don't generate any cash flow and may be used to hedge or speculate.
Tips to Keep in Mind
Traders and investors should understand the tax implications with each strategy. Since the IRS treats digital currencies as property, they are taxed in the same way as conventional stocks and bonds. Long-term investments are taxed at lower capital gains rates than short-term investments held less than a year. Higher turnover leads to higher tax and transaction costs.
The IRS' tax rules require all traders and investors to pay capital gains tax on sales, which involves calculating the cost basis and recording each transaction. ZenLedger simplifies the process of aggregating transactions, calculating the cost basis, and completing Form 1040 Schedule D, Form 8949, and other IRS tax forms that are required for crypto transactions.
ZenLedger's Tax Preparation Software - Source: ZenLedger
Try ZenLedger to simplify your taxes and ensure accuracy.
In addition to tax considerations, traders and investors should carefully choose crypto exchanges. It's important to consider transaction fees and spreads, cryptocurrency liquidity, research and analysis tools, insurance, and other factors. Coinbase Pro is a popular option that provides fair pricing, transparent operations, and insurance against loss.
The Bottom Line
Cryptocurrencies have become an important asset class for a variety of different traders and investors. Whether you're a crypto enthusiast, long-term investor or a short-term trader, there are opportunities to make money from the attributes and behaviors of cryptocurrencies in the market. The key is knowing where you stand and using the right forms of analysis.
If you're interested in simplifying your taxes, try ZenLedger's cryptocurrency tax solution to automatically aggregate transactions, calculate cost basis, and pre-fill the IRS forms that you need to remain compliant with the IRS.