Bitcoin trading and the blockchain

Introduction

Bitcoin, once a fringe interest of a few cryptographers and programmers, has been one of the most remarkable success stories of the twenty-first century. For years merely a speculative asset, Bitcoin is now accepted as currency by multiple nations and traded in immense volumes each day. CFD traders have been quick to move in on this volatile market, where huge rallies and sudden crashes are the order of the day. Trading Bitcoin requires both a solid understanding of the underlying technology, which is underpinned by the blockchain, a distributed ledger providing a public record of all Bitcoin transactions. Additionally, the price action of Bitcoin is specific and unusual, both in its volatility and in its sometimes surprising correlations with other assets.

Bitcoin: a history

Bitcoin is the brainchild of Satoshi Nakamoto, a pseudonymous author or group of authors who released a 2008 whitepaper dealing with what was then a fringe issue for monetary theorists and cryptographers. To this day, there has been no conclusive identification of Satoshi, who – if he or she is still alive – is likely one of the richest people on earth. Bitcoin was not the first digital currency, and was specifically designed to address deficiencies in 1990s precursors like eCash and Bitgold. The problem earlier cryptocurrencies faced were twofold: reversibility of transactions, and double spending.

The blockchain offered an innovative solution to both problems. Reversibility is a common problem for cash-based traditional finance, with major banks or exchanges sometimes reversing trades under pressure from clients or investors. This undermines confidence in the market and creates unfair distortions, where certain clients are able to warp the financial system to act in their favour. Double spending refers to a problem where cryptocurrency users can spend the same coin twice, a problem which in the traditional financial system is solved by a central trusted third party such as a bank. The entire idea of cryptocurrencies is to provide a financial system that’s independent of trusted third parties, so this solution is unacceptable.

The insight of Satoshi was that by making a public ledger of all transactions Bitcoin users would be able to easily confirm transactions, and also track the provenance of each coin, preventing double spending without a third-party overseer. To do so, Bitcoin ‘miners’ are rewarded by solving increasingly complex cryptographical puzzles which confirm blockchain transactions, ensuring the integrity of the blockchain for other users. They receive payment in Bitcoin, until the last of the 21 million fixed coins has been issued. After then, barring a Bitcoin fork following the example of Bitcoin Cash, no more coins will be issued, with the fixed supply intended to combat inflation and devaluation of the coin.

Bitcoin price action

Bitcoin’s price increased by 12,000 times – not percent – between 2010 and 2013. This was followed by a rapid 50% sell-off, setting the pattern which has continued to date, albeit with a smaller ramp up. By the late 2010s Bitcoin was making headlines worldwide as either the most ridiculous hype-fuelled bubble in history or most impressive technical invention, both assessments proving wide of the mark. Beneath the very obvious frenzy of speculation, Bitcoin has also progressed as a payments system, now accepted as legal currency in El Salvador and easy to spend online, including (ironically) via banks or other mainstream financial institutions.

Bitcoin has also spawned numerous other cryptocurrencies, such as Ether (sometimes known as Ethereum), Ripple, Litecoin, and Bitcoin Cash. Bitcoin Cash was born out of a blockchain fork with Bitcoin, and represents a slight update of its protocol, whereas Ether has more profound differences and began an entirely new blockchain at inception. These coins are fairly well-accepted and trade in significant volumes. More controversial are ‘stablecoins’ such as Tether, which claims to hold billions of dollars in reserves to maintain a 1:1 peg with the US Dollar (analysts are sceptical, to say the least), or Monero, a cryptocurrency with an obsessive focus on privacy that has long caused alarm among law enforcement agencies. Apart from stablecoins, all of these coins share features in common with Bitcoin in terms of price action, sometimes magnified by lower trading volumes. Those features are extremely high volatility, very powerful sustained trends (in both directions), and general market uncertainty.

Correlation for crypto traders

The correlation of Bitcoin to other assets is important, but unfortunately the last decade or so has given mixed signals. It’s important to remember Bitcoin, relative to other assets such as FX, bonds and commodities, is very recent. The current correlation pattern may change in the future as crypto traders rebalance their overall portfolios. Also, understand that Bitcoin is distinct from traditional financial assets, and though it has some traits in common with FX or commodities it is distinct from the traditional financial system and likely to remain so for the foreseeable future. With those caveats in mind, Bitcoin generally exhibits a positive correlation with other risk on assets such as growth equities, industrial commodities, emerging markets currencies and low-grade corporate debt. In other words, Bitcoin performs well during market upturns, when traders feel confident about economic growth and are willing to take greater risks to ensure returns. Bitcoin is inversely correlated with safe haven assets such as global reserve currencies, utilities stocks, gold and high quality government bonds. The peak of Bitcoin prices often coincides with peaks in the overall equity market.

Correlation breakdowns

However, like all market correlations, these effects may sometimes break down. Notably, during the stock market crash at the beginning of the COVID pandemic and subsequent lockdowns, Bitcoin outperformed considerably, continuing to attract new buyers and achieving price records. This means that during that market crash the normal correlation inverted, with Bitcoin positively correlated with safe haven assets and negatively correlated with other risk on assets. Correlations with Bitcoin are also frequently high numbers – a movement of 1% in a safe haven asset like the Swiss Franc may correspond to a change of 5 or 6% in Bitcoin. These correlations are often unstable, and so Bitcoin cannot be used as a hedge to prevailing market conditions with long or short crypto CFDs. This is why Bitcoin can lead to extreme losses as well as huge gains.

How to trade Bitcoin

ADSS crypto traders trade Bitcoin using contracts for difference or CFDs. Contracts for difference are flexible financial instruments that allow two parties to exchange a cash sum based on the price fluctuations of an underlying asset, without either party taking ownership. In essence, the contract is an agreement to exchange the difference in price between the start of the contract and its price on completion. Traders use CFDs to access risks in markets where taking delivery of the asset would be inconvenient or impossible, or where it is difficult to trade fluently in both directions. Because CFDs can just as simply be used to profit from price decreases as increases, they are a useful tool for expressing a negative opinion on the price of an asset. This is particularly true in cryptocurrency markets, where short selling is difficult if not impossible.

There are a few different ways to use CFDs on Bitcoin. ADSS crypto CFD traders can open contracts for difference directly on cryptocurrencies like Bitcoin, Bitcoin Cash, Ethereum and Litecoin. Another option is to trade CFDs on crypto stocks such as Coinbase or Robinhood markets, whose prices are strongly influenced by the value of trading volumes of Bitcoin. Finally, ADSS CFD traders can open long or short CFDs on two Bitcoin ETFs, the iShares Bitcoin Trust and Fidelity Advantage Bitcoin ETF, two exchange traded funds that track the price of Bitcoin.

Other uses for Bitcoin

Satoshi did not design Bitcoin so that traders could speculate on its price. In fact, unlike in commodities markets where speculators play an essential role in price discovery and allow hedgers to take out positions, speculation on Bitcoin does not help whatsoever with its original purpose: payments. From its beginnings, Bitcoin and other cryptocurrencies were supported by a small, ideological core of cryptographers and tech entrepreneurs with interests in privacy, payment security, and shared criticisms of the financial system. Today, the overwhelming majority of traded Bitcoin volume is by speculators, often with a cursory interest in these factors. The future of Bitcoin will depend on the actions of the entrepreneurs, businesses and now national governments who see it as a long-term investment in an independent, decentralised financial system.

Blockchain technology has many potential applications outside of Bitcoin, as the growth of digital assets such as NFTs in recent years neatly illustrates. Smart contracts are one area of significant investment which has captured the imagination of many. A smart contract is a program, stored on a public blockchain, that is executed automatically when certain conditions are met. For example, you could open a contract to send 1 BTC to another wallet when a 30-day period from the start of the contract expires. By making this contract public on the blockchain, everyone can see the contract has been made and agreed, and it will execute automatically when the conditions are met. This is a very simple example, but in theory it would be possible to maintain multiple blockchains storing contracts such as mortgages or loans, ensuring full visibility and on-time payment. The obvious question of privacy can be solved with a blockchain fork, providing a smaller sub-blockchain that only certain parties have access to, but which remains online and can be confirmed at any point.

The future of Bitcoin: traders or investors?

As CFD crypto traders, we are primarily interested in short term price action. But it would be foolish to ignore the potential uses of blockchain technology, crypto assets and smart contracts, since inward investment to these fields directly impacts the price of Bitcoin. Many smart contracts are executed using Bitcoin or other cryptocurrencies, so the trading volume is directly impacted by the growth of these fields. Additionally, general market sentiment in the cryptocurrency market tends to follow interest in tech more generally, so successful applications of the technology will tend to boost Bitcoin’s price too. Speculators should take press coverage of the tech industry and especially cryptocurrencies as a positive signal for Bitcoin prices.

Trading with caution

Bitcoin is a highly volatile asset; this is what makes it so attractive to traders but also of course makes good risk management practice more important than ever. The usual rules around position sizing, leverage, and stop losses must be followed, but the price action of Bitcoin also creates a few new concerns. First of all, it is that sudden price swings may jump past stop losses, forcing you to accept a greater loss than you had planned. The next is that leverage should be used with much greater caution than in more stable markets such as FX CFDs. Although Bitcoin is often traded as a currency pair with the USD, do not be fooled into using the same level of leverage for Bitcoin as you would with a major reserve currency. More than anything else, this is simply unnecessary as the price action of Bitcoin is sufficient to generate substantial profits without leverage.

Summary

Cryptocurrencies and blockchain are transformative technologies that are here to stay. It doesn’t necessarily follow that Bitcoin will preserve or increase its price, that any given smart contract or similar technology will work, or that the entire sector will grow. So far Bitcoin’s price journey has been characterised by flurries of investor interest then sudden, prolonged crashes. This will likely continue. But Bitcoin has established itself because the protocol laid out in its 2008 white paper worked, and solved real problems within its niche. This is important to remember for Bitcoin CFD traders, even if we are more interested in short term price action, because the remarkable explosion in crypto trading is fuelled by investor sentiment. If investors cool on the long term future of Bitcoin, prices will fall as suddenly as they have risen.

Understanding a bit about blockchain, blockchain forks, smart contracts and everything else in the sphere will help you become a better crypto CFD trader, instead of just manically following trends. The price action of Bitcoin is unique, with a strong bias towards trend following strategies advised for traders. Correlations with Bitcoin are liable to change in unusual market conditions, as seen during the 2020 stock market crash. Bitcoin profits are inherently unstable, so traders need to approach these assets with caution and intelligence, using stop losses effectively on both long and short CFD positions. With discipline and attention, Bitcoin CFDs can be an exciting market, but they are one that requires comfort with risk and an understanding of when to walk away.

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