The merits and drawbacks of trading cryptocurrency pairs

May 11, 2018
Chris Wheal

For traders armed with the experience, knowledge, tactics and technical analysis from trading on electronic spread-betting platforms or the popular contracts for difference venues, the concept of cryptocurrency trading will not seem overtly alien.

Derivative alternatives to trading cryptocurrencies are now becoming widely available since CME Group announced in November 2017 it would begin trading Bitcoin futures.

Bitcoin and some of its rivals

Many contract-for-difference (CFD) trading platforms now quote and trade digital currency derivatives in the form of CFDs, an easy way to day trade cryptos, but a risky strategy for those looking to buy and hold cryptocurrencies as an investment.

However, only margin staked up front in the form of domestic fiat currency is acceptable on these trading venues. What, then, are the advantages of trading in crypto pairs? Why would we choose to convert dollars, say, into a crypto base currency to begin trading other cryptocurrencies?

Some advantages of trading crypto pairs:

1. Volatility

Firstly, it smooths volatility. Volume and liquidity in cryptocurrencies are still extremely low when compared with equity markets or foreign exchange. This has made trading cryptos against established currencies a very volatile affair.

In a paper for Queensland University, Wang Chun Wei examined the liquidity of 456 different cryptocurrencies, and discovered that while volatility in cryptocurrencies decreased as liquidity increased, the predictability of returns remained clouded.

Although Bitcoin returns appeared more efficient, many other cryptocurrencies exhibited signs of autocorrelation and non-independence. Wang concluded: “Liquidity plays a significant role in market efficiency and return predictability of new cryptocurrencies.”

If, for example, you’re day trading Bitcoin versus the dollar and Bitcoin rises 8.5% against the US currency, on a $1,000 investment you’ve gained $85.

But, as Wang found, many cryptocurrencies tend to move in sync against the dollar and other fiat currencies – not all at the same rate, but on any given day, if Bitcoin is up 8.5%, the other main cryptos will also have risen on the day. This tendency to correlate against the dollar lessens the volatility between altcoins.

Let’s look at the EOS/US dollar cross against the EOS/Bitcoin cross as an example. Since the start of 2018 to its peak on 29 April, Eos gained 657% versus the dollar but only 307% versus Bitcoin.

Conversely, since this peak Eos has fallen 46% against the dollar, but just 36% versus Bitcoin.

While the gains for the crypto pair fall short of those for the crypto/dollar, the losses are smoothed. Volatility on both the buy and sell side is reduced – an important factor for those buy and hold investors trying not to lose their nerve.

Federal Reserve building

2. Economic data and central banks

Trading traditional currency pairs, or even one fiat currency against a crypto, runs the inherent risk of loss through data shocks and any subsequent response by central banks.

Inflation and other economic data has no major impact on cryptocurrencies. Nor do hikes or cuts in interest rates by central banks.

3. Geopolitical turmoil

Cryptocurrencies are largely immune from the effects of war, political sanctions and other forms of international sabre-rattling.

While such events can negatively affect trade between domestic currency and crypto, certain cryptocurrency pairs may move to the trader’s advantage in times of international turmoil.

Some disadvantages of trading crypto pairs:

1. Cost

You may run into some initial transaction costs in transferring your fiat currency into a digital base currency. Much depends on the exchange you choose.

If you’re a long-term investor, look also at whether the exchange is geared towards day trading as charges for holding open positions overnight could be applied.

2. Lack of directional drivers

As explained above, movement in crypto pairs isn’t driven by economic data or global politics so direction of trade is very difficult to predict. The cryptocurrency complex tends to move in the same direction each day – it’s mostly only events specifically relevant to a particular digital currency that will make it move independently of the crowd.

Cyber attacks on altcoin wallets will influence prices

Examples of such events might include news of theft by fraud or hacking of a Bitcoin exchange; news of partnerships between coin issuers and large corporations or news of investigations by regulatory authorities.

3. Value ratios

When trading fiat currencies or a fiat with a crypto, the cross is usually valued in something familiar to us – dollar, sterling or euro for example.

When trading crypto pairs, the cross is valued in the base cryptocurrency. This can represent an unfamiliar and difficult to understand set of information – made more bewildering if you then attempt to convert back into your domestic currency.

How trading crypto pairs works

While trading cryptocurrency pairs is rather complicated, it’s still available to anyone. Currency trading directly on global foreign exchanges isn’t.

Forget spread-betting or CFD trading platforms – these merely allow private investors to speculate on asset price moves. While fiat and cryptocurrencies can be backed on these trading venues, there’s no actual participation by investors in the primary markets here.

Nevertheless, to trade cryptocurrency pairs requires a number of important steps and care should be taken.

Buying a base cryptocurrency

There are more than a thousand cryptocurrencies, many of which cannot be bought with your domestic currency. All, however, can be bought using Bitcoin, which many traders consider the base cryptocurrency. However, many exchanges accept domestic currencies to buy alternative base cryptocurrencies such as Ethereum and Litecoin.

To buy your base cryptocurrency using dollars, sterling or any other domestic currency requires setting up a trading account with a crypto exchange.

Traders can get their fingers seriously burnt here as there are many hundreds to choose from and vary in quality from the excellent, down to the scammers. To make sure you don’t become a victim of the latter, do your research.

While it may be better to go with those among the most used, check the fees (deposit and withdrawal fees are common) suit your likely usage. Some will only accept deposits in dollars, which will mean another transaction fee if you’re not conducting your business in the US currency.

Read the press on cryptocurrencies and know which exchanges have come under scrutiny for dubious practices.

Cryptocurrency wallets

This is an electronic program where you can safely store your digital currencies and enable you to send and receive them through the blockchain and also allow you to monitor your balance.

While crypto exchanges host their own wallet schemes, they can lack the security of an off-exchange wallet: in January 2018, hackers found their way into a digital wallet hosted by Tokyo’s Coincheck exchange and stole Y58bn ($530m) in NEM tokens.

Many, therefore, choose wallets separate to their exchange. Again, do your research and choose carefully.

Cryptocurrency hardware wallet

Trading on crypto-only exchanges

This next step is more complicated as it involved opening another exchange account: this time one that only accepts cryptocurrency deposits.

When you bought your base cryptocurrency using dollars, the value of your holdings was quoted in dollars. On this second, crypto-only exchange the value of your holdings will be quoted in your base cryptocurrency.

Understanding altcoin value ratios

We hinted above at the difficulties in understanding the value ratios when trading crypto pairs. Let’s break this down a little further.

Consider the example of trading the Stellar/Bitcoin crypto pair. As of publishing, one lumen – Stellar’s currency unit – can be bought with $0.3223. A cost of just over 32 US cents is simple to understand, but the matter becomes complicated when we look at how many Bitcoins – our base cryptocurrency – it takes to buy one lumen.

One Bitcoin is currently worth $8,490. As seen in the XLM/BTC chart, it currently takes 0.00003794 Bitcoin to buy one lumen.

Monitoring your gains or losses in dollar terms, therefore, is impossible to spot just by looking at the price action on the chart and means a mathematical conversion back – one that could go wrong and misrepresent your total holdings.

Nevertheless, these are increasingly popular trades and some websites and trading exchanges include a converter.

Statistical information

Let’s take a look at the current most popular crosses using Bitcoin and Ethereum as the two most popular base cryptocurrencies.

Bitcoin: by far the biggest volumes of trade are in Bitcoin, both in fiat-crypto pairs and crypto-only pairs. Daily volume by currency in Bitcoin is predominantly in Japanese yen – 54.5% according to Cryptocompare.com. US dollar represents 18.5%, Tether is 17.2%, while Korean won and the euro represent much of the rest.

Daily crypto-pair trades, with values expressed in Bitcoin, show that traders using Bitcoin to buy more Bitcoin is the biggest trade (about BTC290K, or about $2.5bn). The second biggest volumes are for Eos (BTC94.6K, $803m) and third Ethereum (BTC88k, $747m), according to data from Cryptocompare.com.

Ethereum: is the second biggest crypto by market capitalisation and it generates the second largest volumes in trade. Volume by currency in Ethereum is 40% in Bitcoin, 26.4% in Tether, 19.4% in US dollar, 8.5% in Korean won and the rest in euros and other currencies.

Daily crypto-pair trades, with values expressed in Ethereum, show the biggest volumes are for Bitcoin with ETH3.49m ($2.47bn). Second is EOS (ETH1.14m, $806m) and third is traders using Ethereum to buy more Ethereum (ETH1.04m, $735m).

What the traders say

Traders are very shy to openly talk about their cryptocurrency transactions when approached by a reporter, but they are more than willing to share their experiences with each other on public forums. In lifting their thoughts from the myriad of online chat rooms, their blushes have been spared as names and other public profiles are kept anonymous, but in the interests of attribution, the forums themselves have been named.

Cryptocurrency traders

A theme that persisted was that of costs, prompting a trader on Reddit to comment: “I use ETH pairs because BTC transaction fees are disgusting at the moment.”

In response, this investor said: “I’ve no idea why exchanges aren’t adapting faster. Having BTC as a trading pair with its four-day confirmations and $30 fee makes zero sense. It’s faster and cheaper to deposit fiat.”

The question of volumes was also high on traders’ list of priorities. This day trader, also commenting on Reddit, said: “I almost always stay with a BTC pair since the BTC pairs seem to always have more volume. I don’t want to sit around waiting for an hour for my order to be filled.”

Here on Steemit, the concern is about the difficulty in monitoring gains between pairs. “Maybe one day we will be thinking more in terms of ETH and BTC and it won’t be so confusing to have to do all the conversions to see what is more valuable.”

This trader has also had some difficulties: “What I find so confusing about trading with BTC is that at first glance it might look like I am losing money because my altcoin is going down against BTC but it is not because BTC is going up against the USD.”

Few, even here, are willing to talk about their most profitable trades or, indeed, their most disastrous. It appears that the major issues are those of liquidity and costs.

Liquidity is important because once a trader has entered into a transaction at a certain price, the volume of trade needs to be sufficient that the buy, or sell, order can be matched at the desired price and time. If not, the trade could go terribly wrong.

Costs are an important issue and can vary from location to location, depending on exchange transaction fees and the trader’s domestic tax laws.

Conclusions

Diversity is an important aspect of any investor’s portfolio and there’s a place for cryptocurrencies in there. The market – still in its early days with little institutional backing and, therefore, short on liquidity – warrants a cautious approach and few experienced investors would allocate more than a very small percentage of their portfolio to cryptocurrencies.

But many expect this market to be highly active in the coming months as institutional funds begin to flow in and – given the massive gains we saw at the beginning of the year – it would be a shame to miss another such opportunity, if it comes.

In the past, many cryptocurrency price movements happened independently of one another and trading pairs made a lot of sense. More recently, they’ve tended to move as one, and large gains within the sector are more difficult to predict.

So, costs aside, if there is going to be another surge in positive sentiment for cryptos, it may be more profitable to stick to the dollar/crypto crosses.

But when the market matures, news of breakthroughs by companies such as Stellar – forging business partnerships with cross-border payments firms – are likely to make each cryptocurrency more like equity in a company that stands alone and rises, or falls, on its own merit.

 

All images by Shutterstock

Post written by Chris Wheal
Chris Wheal is editor of OpenLedger's news and features service. An award-wining business journalists himself, he runs a team of freelance journalists from across the UK and north America.

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