An introduction to Bitcoin

Introduction

Bitcoin was one of the biggest stories of the 2010s and has provided some of the most dramatic price action ever seen in any market. In fact, no asset has ever undergone price rises as significant as Bitcoin and other digital assets. The volatility swings in two directions though, and price action in cryptocurrency markets is violent, moving significantly according to overall sentiment. Contrary to popular belief, Bitcoin was not the first digital currency, but it was the first to capture the public imagination and achieve widespread acceptance. Today Bitcoin is the model for a broad range of digital currencies and other virtual assets which rely on modified versions of its distributed ledger with proof of work, known as the blockchain. ADSS CFD traders can share in long and short price action on cryptocurrencies without owning the underlying asset, but to understand the market, it is still necessary to grasp the basics.

Some Bitcoin history

By far the most popular cryptocurrency despite the multiplication of challengers in recent years, Bitcoin was introduced in a 2008 whitepaper by an unknown author or team writing under the pseudonym Satoshi Nakamoto. Speculation on the real identity of Satoshi has continued ever since. Designed to operate without central banking authority or government interference, the Bitcoin white paper laid out Satoshi’s idea for a peer-to-peer electronic cash system. The coin itself was first generated by solving the first block of Bitcoin’s proof of work algorithm, with block zero minted in January 2009. The technology behind Bitcoin’s proof of work is a distributed ledger known as the blockchain, a decentralised ledger that records all transactions across a network of computers. This system is designed to avoid ‘double spending’ of coins, a persistent problem for earlier digital currencies.  To avoid this problem, Bitcoin transactions are verified by network nodes through cryptography, and these transactions are grouped into blocks that are linked in a chronological chain, forming the blockchain. Bitcoin miners are rewarded with a fixed supply of coins for solving increasingly difficult puzzles to validate blockchain transactions, with a fixed cap of 21 million Bitcoin.

Bitcoin’s price action has experienced logarithmic growth, with a huge rally from $0.10 in 2010 to over $1200 in 2013, followed by an aggressive bear market. Since then Bitcoin has experienced further extremely significant rallies, for example in 2018 and 2021, again followed by selloffs of 50% or more. This has made the fortunes of a few lucky traders, but also wiped out many investors who entered near the top of successive rallies. Bitcoin price action will be explored in more detail later, but the asset follows an exaggerated risk profile, similar but more extreme than industrial commodities or tech stocks. Because Bitcoin is seen as a risky but potentially lucrative investment, traders tend to buy it when they are confident about overall economic growth and the success of the rest of their portfolio, and sell during market wobbles. The correlation with the stock market is not perfect, however, with Bitcoin seeing strong gains throughout the 2020 market crash.

Precursors

Bitcoin was the first digital currency to achieve widespread use, but it was not the first example of one. B-Coin, eCash and Bitgold were all launched earlier, with eCash taking the lead in 1990. These coins all failed, but were influential in the eventual development of Bitcoin, with the name a homage to Bitgold. Another early cryptocurrency of significance is Hashcash, and between these early examples most of the eventual features of Bitcoin were already present. eCash was launched in 1990 by a company named DigiCash, building on the work of David Chaum, an American cryptographer. eCash used a public security key to confirm digital money that could be held with a bank, offering a payments system without credit cards. As a micropayments system eCash operated with a single bank for a few years in the 1990s, never achieving widespread adoption. Other pioneers in the field included Adam Back (Hashcash) and Nick Szabo, whose Bitgold included proof-of-work algorithms and many other eventual features of Bitcoin. All of these currencies suffered from problems around double spending and reversibility, with eCash dependant on a traditional banking firm for its operation. These were the challenges that Satoshi set out to deal with in 2008.

The Bitcoin white paper

The Bitcoin white paper identified several problems with existing fiat currency and payments systems, and proposed a digital currency, Bitcoin, as a solution. The main problems identified were trusting third party institutions such as central banks, providing non-reversible transactions, and preventing double-spending of tokens without a third party to verify transactions. Up to this point, no one had found a satisfactory solution to the problems of reversibility and double spending that didn’t require a trusted central authority. The solution Satoshi came up with was to use a time stamp server with proof of work: this he dubbed the blockchain. Finally, the white paper details some Bitcoin guides on how to avoid a successful theft or attack on the network.

The reversibility problem is a major criticism of bank-based finance, and the Bitcoin white paper points out completely non-reversible transactions are not really possible using banking or a third-party mediated payment system. A reversible transaction is one where participants can pull out of the payment after it has been agreed, a rare but problematic event on stock exchanges and with banks. Centralised exchanges such as the London Metals Exchange have been criticised in the past for allowing the reversal of trades due to pressure from major clients or governments. One benefit of digital currencies is there is no trusted third-party, so transactions take place automatically and cannot be reversed, with the blockchain providing a list of transactions publicly available on all connected CPUs.

The other challenge, avoiding double spending, is normally solved by a central authority checking transactions. Satoshi wanted to avoid this reliance on a centralised third party, so the blockchain is publicly available, and you can see the spending history of each bitcoin (or subdivision) online. This prevents the same wallet from sending the same coin to two different wallets, preventing double spending. The blockchain is divided into blocks, which are made up of multiple Bitcoin transactions, then simplified into a hash or code. This provides a method for checking the integrity of the blockchain, as different hashes should always align with the rest of the chain, with new blocks being added as more transactions occur. Bitcoin miners validate the chain by solving increasingly difficult puzzles aimed at validating the most recent blocks. Mining a new block of Bitcoin is rewarded with a coin, up to the fixed limit of 21 million. Because the proof of work involved gets exponentially harder, it is likely the last Bitcoins will never be mined.

Bitcoin’s uses

Bitcoin is the implementation of the principles laid out in Satoshi’s white paper, and understanding it is an important introduction to Bitcoin, but the mechanics are really of secondary interest to most CFD traders. CFD traders are speculators, looking for assets with highly volatile price profiles to trade market movements indirectly, without taking ownership of the underlying asset. Cryptocurrencies are the most volatile assets in existence, so unsurprisingly they are very popular with CFD traders.  Though the vast majority of overall traded Bitcoin volume is speculative, it also works as a digital currency, and large sums are exchanged to buy and sell assets in the same way as any other currency.

Speculation

The majority of trading volume in Bitcoin is speculative, with investors interested in the asset for its past price action and the hope of realising similar gains. Despite the growing acceptance of Bitcoin for payments, with the cryptocurrency recognised as legal tender in El Salvador, use of Bitcoin as a regular currency makes up only a tiny fraction of overall volumes. Most Bitcoin buyers do so because they believe it will increase in value – a source of frustration for its opponents, who see no intrinsic value in the cryptocurrency. These critics have included some of the biggest names in finance, counting Warren Buffet among them, but have done nothing to dent the overall popularity of Bitcoin. In fact, a regular pattern emerges, where each downturn in the price of Bitcoin is viewed as proof it is worthless and rallies tacitly ignored: while it is still theoretically possible for the price to fall to zero, the coin does seem to be well-established enough that it is going nowhere, for now.

Payments

Bitcoin is a digital currency, and is accepted as payment universally in two countries, as well as at a host of businesses and websites. It is also simple to convert Bitcoin into cash using exchanges, although some purists view this as accepting the oversight of a third party, and so against the original spirit of Bitcoin. For payments, vendors accepting Bitcoin will advertise the price of their goods or services in coins. You can then make a direct transfer to their Bitcoin wallet address, which will shortly be confirmed on the blockchain. Once the distributed ledger is showing multiple confirmations, the transaction is complete. The first successful Bitcoin transaction was for the sum of 10,000 Bitcoins, to buy two pizzas. Since then, transactions in all markets, from luxury cars and property down to takeaways have taken place using Bitcoin or another cryptocurrency. Increasingly, regular financial institutions such as banks allow their clients to hold Bitcoin in dedicated accounts, and use it for purchases or investment at will.

Trading Bitcoin with CFDs

Bitcoin was designed to escape reliance on third parties such as banks or other intermediaries. One of the biggest problems since has been the untrustworthiness of the centralising organisations that give traders access to Bitcoin; ironically, many people today buy it through their bank. The other point of weakness has been exchanges, with multiple collapses and even criminality on the part of some of the best known cryptocurrency exchanges. These sites offer people the opportunity to buy Bitcoin and hold it in a secure wallet, making purchases by credit card or bank transfer. This cross-over point between the traditional financial system and the world of digital assets has predictably become a minefield.

As you probably know, CFDs do not give the holder ownership of the underlying asset. That means you share in none of the risks (or benefits) of decentralised digital currency, but simply profit (or lose money) based on price action. This is perfect for speculators who do not want the risk of dealing with a cryptocurrency exchange, or the hassle of maintaining cryptocurrency assets. When you open a position on Bitcoin with an ADSS CFD, you are agreeing to exchange a cash value equivalent to the difference in price between the opening and closing values of your trade. Neither you nor ADSS buy Bitcoin or take ownership of any digital assets. This is ideal for speculators, and offers the opportunity to easily short Bitcoin, which is otherwise quite difficult and involves borrowing coins. CFDs are one of the only ways most traders can profit from downward price action in the cryptocurrency markets, making them an ideal option for those bearish on digital assets.

ADSS clients can also trade CFDs based on Bitcoin ETFs, including Fidelity Advantage Bitcoin ETF and iShares Bitcoin Trust. These funds track the overall price movements of Bitcoin, so you can simply open a long or short position based on your view of its price trajectory. Another method is to trade CFDs on Bitcoin-related stocks such as Coinbase, which tend to track the price of Bitcoin. When trading CFDs on the shares of an individual crypto company as opposed to an index, remember that other factors than the price of Bitcoin may also influence returns. When trading Bitcoin with CFDs, it’s always important to remember to use risk management strategies, to mitigate the potential for losses to your capital.

Bitcoin price action

Bitcoin tends to experience its peaks in line with the broader stock market; it is a classic ‘risk on’ asset and highly correlated with the S&P500 and especially growth sectors such as tech. During market downturns traders rotate quickly out of Bitcoin, and it is known for tremendous market crashes as well as strong rallies. Trading cryptocurrencies is not for the faint-hearted, and their price action will make more cautious traders run. Cryptocurrency CFD traders trade Bitcoin, whose price can be expressed in any currency but most commonly in terms of Bitcoin value to USD.

The most common cryptocurrency chart is Bitcoin USD, using either lines or candlesticks to express the price history. There is no functional difference here, and candlesticks are not as popular for crypto traders as in other markets such as FX. One of the reasons traditional technical analysis is less effective is the speed and intensity of market movements; this has led to simple, trend-following strategies becoming the norm, identifying an uptrend and holding on as long as you are willing to accept the risk. For traders who experience dramatic gains and want to keep the position open, selling half of the value of the trade at the take profit level instead of closing it completely is sometimes an option. This was especially the case during the various 100 – 1000% rallies in Bitcoin in the 2010s. Most analysts no longer see the same enormous potential upside to Bitcoin as a few years ago, but it remains a high yielding asset when traded correctly.

Compared to other assets, be they equities, forex or indices, Bitcoin experiences dramatic rallies and sharp corrections. Traders trend to favour trend following strategies, since in such a volatile asset it is difficult to identify overbought or oversold conditions. Some traders would argue Bitcoin is near continuously overbought: as always, metrics such as the RSI need to be adapted to the special characteristics of each market. In Bitcoin’s case, this means accepting great volatility. Bitcoin CFD traders can use their ADSS trading or demo account to open both long and short positions without taking delivery of the underlying asset.

Summary

Some of the details of how Bitcoin works are technical, and readers wondering how to start cryptocurrency trading want short answers. Fortunately, for CFD traders, the only think you have to understand is the price action. Traders who are interested in these volatile assets will certainly benefit from a thorough understanding of the underlying technology behind Bitcoin, but spending time with the price chart and watching live market movements is an excellent way to familiarise yourself with this asset. Even more so than for other markets, cryptocurrency CFDs are highly volatile and not to be traded lightly. Alongside the impressive rallies, Bitcoin has seen multiple 50%+ crashes which can happen suddenly and wipe out your positions, a particular concern for traders using leverage. To protect yourself, you need to use all of the familiar tools from risk management in forex or equity CFDs, and apply them to the realities of a highly volatile, exotic financial market. In practice, that means smaller positions as an overall percentage of your portfolio, strict stop loss discipline, and often a preference for trend following over mean reversion trading strategies. With these precautions, the world of crypto trading will become a – slightly – safer place to do business.

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