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If You Want To Stick a Toe in Bitcoin’s World … Read This First

This short guide offers a quick introduction to the two biggies, Bitcoin and Ethereum

At Expensivity, Bernard Fickser, who has explained how to sell non-fungible tokens (NFTs) now offers “The Truth About Cryptocurrencies: A Clearheaded Guide to the Crypto World.” (January 15, 2022) For your convenience, we are serializing his work, which can be read in whole here. Here’s Part 2:

1 Quick Entry into Crypto Investing

This first section is for those who want to begin investing in crypto right away. But it is also for those who simply want to understand cryptocurrencies without investing in them. Later sections will present the underlying theory and history of crypto, as well as reasons to take crypto seriously but also to be cautious. Yet it helps to see how cryptocurrencies actually behave in practice, and nothing beats buying some crypto at an exchange, setting up a crypto wallet, and then sending some crypto from one wallet to another. So, in a clearheaded guide to the crypto world, it’s good to start with a practical section like this

To be a successful crypto investor, however, you’ll also need a general grasp of cryptocurrencies, The later sections of this article therefore provide a solid overview of cryptocurrencies. If you want to dig still deeper into the crypto world by investing in or even creating non-fungible tokens, you should also read our companion piece on non-fungible tokens.

1.1 The Bare Basics

In explaining crypto investing, we’ll focus on investing in Bitcoin and Ethereum, the two most popular cryptocurrencies with the highest market capitalization (all the other cryptocurrencies together don’t have the value of these two). Investing in other cryptocurrencies is straightforward, and simply means going to exchanges or websites that handle them, buying those cryptocurrencies there, and then procuring the appropriate (crypto) wallets that allow you to move such currencies from wallet to wallet. Specific (crypto) wallets have specific private keys and are designed to work with specific currencies.

For Bitcoin and Ethereum, the exchange I’m going to recommend is Coinbase. In our Expensivity article on the 10 best crypto exchanges, we rank Coinbase as best for first-time cryptocurrency investors. Hence, to buy bitcoins and ether (note that for Bitcoin the plural is either “bitcoins” or “bitcoin”, but for Ethereum the plural is simply “ether”; note also that these are abbreviated respectively as BTC and ETH), simply sign up for an account at Coinbase and transfer funds to the account with which to buy these cryptocurrencies.

Unlike a few years ago, government regulation and IRS intrusion into the crypto world has since gotten much more extensive, so you’ll need to verify that you are who you claim to be (KYC, or Know Your Customer, is a big deal these days with the exchanges). Once you are signed up and have funds in place, you can buy your first bitcoins and ether. As it is, Bitcoin is at the moment trading around $50,000 per BTC ( a month ago it was at an all-time high of almost$70,000) and Ethereum is trading above $4,000 per ETH, so it’s likely you will only be buying fractional bitcoins and ether. Next, get yourself a Bitcoin wallet (I recommend Electrum) and an Ethereum wallet (I recommend MetaMask). Coinbase will now allow you to transfer cryptocurrency to those wallets and from there you can transfer cryptocurrency to still other wallets. You are now good to go in having these cryptocurrencies available to you for the purposes of buying, selling, and investing. Using the these wallets is straightforward, but do a Google search on these or any other wallets you choose to use if you get stuck. Once you set up a crypto wallet, you’ll be given a sequence that looks like this (which happens to be the one associated with my MetaMask wallet): That’s the public address of the wallet. It’s readily copied to your clipboard. You’ll need such an address for people to send you crypto or to send yourself crypto from an exchange. Associated with any crypto wallet is a 12-word seed phrase, which you obtain when you set up your wallet. If you lose the seed phrase, you lose your wallet and everything in it. It’s typically advised that you write down the seed phrase on paper and keep it entirely away from digital storage. Unfortunately, paper is easily misplaced, and reports abound of people losing incredible amounts of cryptocurrency by forgetting or misplacing their seed phrase. I therefore prefer to record the seed phrase in an image file, and then hide the image among a vast horde of other images where it gets tucked away inconspicuously unless you know what you’re looking for. NOMENCLATURE: In the crypto world, you’ll see references to “cryptocurrencies” as well as to “tokens.” Cryptocurrencies are encrypted digital currencies that are native to particular blockchains and thus specifically created for them. For instance, bitcoins make up the currency native to the Bitcoin blockchain, and ether make up the currency native to the Ethereum blockchain. A unit of a cryptocurrency is typically referred to as a “coin.” Cryptocurrency blockchains can also allow transactional protocols or smart contracts. These are computer programs that run on cryptocurrency blockchains and allow for the creation of exchange mechanisms that transact units distinct from but also derived from the underlying cryptocurrency. Such derivative units are called “tokens,” and they can act like cryptocurrencies in their own right, but also serve other purposes (as, for instance, vouchers, rewards, or rebates). The Ethereum ERC-20 standard, at the time of writing, supports 200,000 different tokens. One such token is the Basic Attention Token, which functions like a cryptocurrency but also like an open-sourcedecentralized ad exchange platform. Although the analogy is imperfect, it can help to think of the relation between tokens and cryptocurrencies as the relation for financial instruments between derivatives (such as options and futures) and underlying securities (such as stocks and bonds). Tokens are thus built on top of crypto. Even though there’s a valid distinction here, many writers ignore it, describing the coins that make up a cryptocurrency also as tokens. In a sense, a coin native to a cryptocurrency is also built on top of it, so by that token (pun intended), tokens are the more general notion and encompass the coins that make up a cryptocurrency. Thus one will read (in Yahoo Finance) that “Solana’s token is the fifth-largest cryptocurrency by market cap.” The distinction is valid, but it is often breached. Also, one more bit of nomenclature at this early point in our discussion. In the crypto literature, you’ll often find reference to “altcoins.” These are coins or tokens other than Bitcoin and Ethereum, the latter being the gold standard of the crypto world, other coins/tokens thus being treated as second-class citizens. For now, Bitcoin and Ethereum so dominate the crypto world that the “altcoin” designation seems justified. 1.2 Dangers, Pitfalls, and Snares How much crypto gets lost or stolen? According to Business Insider, “People have lost roughly$140 billion in Bitcoin because they forgot their passwords or got locked out of accounts, and would-be millionaires are struggling to access their wallets.” That report was issued in January of 2021, when the price of Bitcoin was about half of what it is now. So with Bitcoin sitting at $60,000 per bitcoin, and thus a total market cap of around$1 trillion, total Bitcoin losses exceed $250 billion, which means that over 25 percent of all bitcoins have gone missing. Imagine if a quarter of your bank account simply went missing. The case of James Howells is particularly poignant. He began Bitcoin mining early in the game (in 2009; Bitcoin was founded in 2008). In 2013 he inadvertently threw away the hard drive with the credentials to his Bitcoin wallet. The hard drive ended up in a landfill and he knows roughly where in the landfill it is. But the city won’t let him exhume the hard drive. On it is the information that will allow him to claim 7,500 bitcoins, valued at half a billion dollars (i.e.,$500,000,000) at Bitcoin’s recent peak price.

As you start buying cryptocurrencies and moving them around between exchanges and wallets, it will feel like you are moving money remotely in the same way as with your bank through its smartphone app. But this similarity is deceiving. Crypto wallets are vulnerable to amnesia (forgetting your access credentials, typically referred to as your private key or the seed phrase that allows you to reconstruct the private key). And they are vulnerable to theft (someone stealing your private key and making off with all the crypto in your wallet). Moreover, there are no laws to redress this sort of amnesia or theft. It’s on you to keep your credentials safe and intact. That’s a lot of responsibility. That means there’s no safety net. And people pay the cost.

Working with a crypto exchange offers some safety against amnesia in that an exchange will have reliable ways of identifying and contacting you, such as through your email account or cell number. But theft remains a big problem. A crypto exchange may feel like a bank, but it is not a bank. The big difference is that with a bank, you have a trusted third party that is legally liable for your deposited funds. Moreover, the Federal Deposit Insurance Corporation insures your deposits at a given bank for up to $250,000. With crypto, whether through an exchange or through a wallet, you are much more on your own. If hackers steal the private key to your crypto wallet, you lose all the crypto in that wallet. Similarly, if hackers break into your account at a crypto exchange, you lose whatever they choose to remove. Even at Coinbase, hackers in the fall of 2021 stole cryptocurrency from 6,000 of its customers (largely through phishing attacks). If a crypto exchange as a whole is hacked, all the crypto assets of the exchange may be compromised. The hacking of Mt. Gox, an early Bitcoin exchange, stands out to this day. Its bankruptcy almost ruined confidence in Bitcoin. In being hacked, Mt. Gox ended up losing 650,000 BTC, worth over$40 billion at Bitcoin’s recent peak price. People who owned those BTC lost them.

I’ve had a Coinbase account since 2016, and in that time I’ve seen Coinbase’s security measures become ever more stringent. That’s encouraging, and it keeps me from being too worried about losing the crypto that I have in my account there. But the recent theft from 6,000 of its customers is less encouraging.

In any case, banks provide additional safety nets that are lacking in the crypto world. If somebody steals your debit card information and starts unloading the money in your bank account, once you catch it, the bank will stop the fraud and, if you are under the $250,000 FDIC limit, will reimburse you for your loss. I’ve experienced this myself when someone stole my debit card information at an airport, and then started buying large items at Best Buy and Walmart. By the time I caught on to what was happening,$2,000 had been removed from my account. Yet the bank, once I pointed out the theft, restored all those stolen funds. Nothing — and I mean NOTHING — like that exists on a crypto exchange.

If you accidentally wire money from your bank to the wrong account or wire the wrong amount of money, your bank will be in a position to reverse the transaction. With crypto, all transactions are irreversible, so once you send crypto, the only way to get it back is by asking the party that received your crypto to give it back. And often that party will be anonymous, so good luck with that.

If you have crypto in a wallet and somebody learns your 12-word seed phrase or the associated private cryptographic key for the wallet, they can transfer all the crypto in the wallet to one of their own crypto wallets, and you’ll have no recourse for retrieving the cryptocurrency that was transferred. Even the legal system is unclear about what it means to steal cryptocurrency. That’s because cryptocurrency theft simply moves around bits electronically on a peer-to-peer network according to agreed upon protocols, and those bits have no legal standing as claims on property. Cryptocurrency theft is a multibillion dollar a year problem, and there is no clear system of legal redress.

Given these caveats, if you still want to invest in crypto, I’m going to propose two approaches. One is simple (dollar cost averaging), and the other requires more work (trend trading). I’m going to assume that you are investing in crypto because, despite extreme volatility, you see the price continuing to go up. In other words, I’m going to assume you are bullish on crypto, and thus will be going long on it.

The alternative to being bullish on crypto is being neutral or bearish about it. If you are neutral, you may just ignore it. If, on the other hand, you are bearish on crypto, thinking that it is ultimately going to crash and burn, or even if you think it is going to go down significantly in the short term, then you will likely want to sell crypto short. Short selling crypto, especially with its extreme volatility, is, however, a recipe for losing a lot of money.

Short selling requires margin tradingwhich Coinbase no longer allows because of recent regulatory changes in the U.S. (Coinbase is based in San Francisco). On the other hand, Binance, based in the Cayman Islands, does allow margin trading and thus short selling of crypto. Here’s a brief video on how to short sell crypto at Binance, but engage in short selling crypto at your own peril.

In this light, it’s worth noting the attitude toward crypto of the hedge fund managers who successfully shorted mortgage-backed securities back during the financial crisis of 2007-08 (such as Michael Burry, played by Christian Bale in the film The Big Short). They made billions when the housing market collapsed in 2008. These same hedge fund managers think that Bitcoin, and crypto in general, is a bubble that ultimately will deflate to zero. Even so, they are unwilling to short Bitcoin on account of its volatility as well as their inability to predict the details of its expected demise.

One final point, which we’ll examine in more detail later, is the inequality with which crypto wealth is distributed. Those who have made the most money off of crypto have gotten in early when the crypto’s valuation was low and have profited as its price skyrocketed. Satoshi Nakamoto, the pseudonymous inventor of Bitcoin, is thought to have mined 1.1 million bitcoins. All these bitcoins have to date gone unused (did Satoshi die and are they forever lost?). Satoshi’s stash of bitcoins represents about 5 percent of all bitcoins that have or will ever be mined (the total being 21 million). At Bitcoin’s peak price to date, that represents about $70 billion. Satoshi’s case is extreme but not unique among crypto founders. 1.3 Dollar Cost Averaging In going long on crypto, you are taking a bullish attitude toward it, thinking that over time it will, on average, continue to rise. In that case, your simplest strategy is dollar cost averaging (abbreviated DCA). In this strategy, you set aside a fixed amount of money and invest it in equal portions at regular intervals until the amount is used up. In the limiting case, this strategy involves nothing more than putting aside a fixed amount for crypto and investing it all at once, such as when it has taken a huge dip after a historic high. Thus, after April of 2021, when Bitcoin hit over$60,000, it came down to about $30,000 that July. If you had been fortunate to invest in Bitcoin at that time, then you would have doubled your money when in October of 2021 Bitcoin went back up over$60,000.

In actual practice, however, dollar cost averaging means setting aside a sum money, dividing it into more than one equal portions, and investing each portion at regular intervals. For instance, suppose you’ve got $6,000. Let’s say you want to invest that amount in a given cryptocurrency, spreading it out over the next four weeks, and so$1,500 per week. Let’s say that the first week this cryptocurrency is valued at $100 per unit, the next week it goes up to$150 per unit, the next week it is down to $50 per unit, and the fourth and final week it is back to$100 per unit.

In that case, you obtain 15 units of the cryptocurrency the first week, 10 the second week, 30 the third week, and 15 the fourth week. That’s a total of 70 units of the cryptocurrency in the fourth week. Because the cryptocurrency in the fourth week is back at $100 per unit, and because you now own a total of 70 units, the value of the cryptocurrency you acquired over the last month is now$7,000, up \$1,000 from what you had to invest at the start.

Note that in this four-week window, the cryptocurrency went up as much as it went down from the starting point, but you ended up gaining because you made back with extra during the low more than you lost during the high. If you’re going long, you always make money by buying low and selling high, and dollar cost averaging allows you to come out ahead as long as buying high doesn’t too much outweigh buying low.

As it is, the consistent pattern, at least for Bitcoin and Ethereum, is that however high these cryptocurrencies have gotten and however much they fall in value, they always eventually rebound and reach new unprecedented heights. If this pattern continues (no guarantees here), it means that dollar cost averaging will make you a return at whatever point you start using this strategy (even if you start at a high because you’ll be making losses back as you invest during the intervening lows and as the currency goes to its next unprecedented high). Or course, dollar cost averaging will make you that much more money the further down in the fall from the last high you start.

One caveat with this strategy: Don’t use this strategy with money that you can’t afford to lose or that you may need to reclaim for some urgent need. If you use this strategy, set aside the money you will use, and invest it according to your plan at the regular intervals specified by your plan. To make this strategy work, you need to stay the course with it.

Even so, recognize that your ability to stay with your DCA strategy may require some courage on your part given the extreme volatility of crypto. This volatility, when it hits a low, may convince you that you’ve invested in a sinking ship, in which case you’ll be tempted to jump ship. To counter this temptation, you may want to automate the investment at each interval and ignore the investments as they are happening in real time. With an investment strategy, it’s also good to have a strategy for dealing with your own psychological reactivity to unpleasant drops that may tempt you to lose heart.

In trend trading (aka technical analysis), you try to capitalize on market momentum as the price goes up or as it goes down. You therefore want to buy as the market is low and sell as it is trending up (toward a peak). Conversely, you want to sell as the market is high and buy as it is trending low (toward a trough). Full-orbed trend traders will thus want to have short selling in their arsenal (so that they can sell the asset in question high even if they don’t own it).

Trend trading looks for patterns in the price movement of an asset and attempts to profit by exploiting those patterns. Does trend trading work? Economist Eugene Fama’s efficient market hypothesis suggests that it shouldn’t work because prices of assets are supposed to reflect all available information about the asset. But Fama’s subsequent work suggests that “extreme momentum tilts” of the sort one sees with cryptocurrencies may be exploited through trend trading.[1]

If you are going to be a trend trader, you really need to do your homework and develop for yourself the tools for spotting trends in the momentum of cryptocurrencies that you can exploit for profit. Some of these tools may be off the shelf, others you may need to build for yourself, and all of them will need to be continuously monitored, adapted, and updated. This can easily become a full-time job.

It’s best to start by simulated trading (often still called “paper trading”) to see how well your system for exploiting trends really works and if it is capable of delivering a profit. And even if you are successful with simulated trading (showing a virtual profit), you need to make sure you stay the course with your trading strategy once your own money is on the line (and thus stand to see a real profit or loss).

If you want to do trend trading, you need to do your homework. A good place to start is Glen Goodman’s The Crypto Trader. For a deeper dive into the type of pattern analysis (also known as “charting” or “technical analysis”) that underlies trend trading, the locus classicus is Thomas Schabacker’s Technical Analysis and Stock Market Profits, with the latest understanding of this field captured in Edwards et al.’s Technical Analysis of Stock Trends (11th edition, 2019).

Unlike dollar cost averaging, trend trading is not something you can just jump into. You first need to learn the ropes. In trend trading there are lots of moving pieces to keep track of. You’ll need to be able to get in and out of trades quickly. This will require conditional orders (such as stop and limit orders) where you can automate buys and sells when prices of the crypto in question reach certain ranges within certain time frames.

One final caveat: As with dollar cost averaging, the money you set aside for trend trading should be an amount you can afford to lose, especially in the early going. Even the best trend traders make plenty of mistakes in spotting and timing trends. As a trend trader, you expect to be losing on some trades and then hope to be making it back with more on others. But if trend trading were a magic bullet, you would see a lot more successful trend traders. The fact that you don’t is itself telling.

The whole series in order:

Part 1: Some brute facts about Bitcoin and other cryptos Crypto is transforming money and finance. Like the computer, you don’t need to use one but you’re wise to know the basics. Start here. Crypto functions much like cash, avoiding or minimizing the increasing ability of government or other big institutions to snoop on who you give money to.

Part 2: If you want to stick a toe in Bitcoin’s world … read this first. This short guide offers a quick introduction to the two biggies, Bitcoin and Ethereum. Whether you are investing or just using the system, you need to be very cautious with passwords. It’s not your street corner bank.

Part 3: As money slowly transitions from matter to information… Let’s look at a brief history of cryptocurrencies — which is not quite what we might think. The mysterious Satoshi Nakamoto, founder of Bitcoin, did not invent new concepts in computer science or cryptography; he put them together in a way that worked.

Part 4: How and Why Cryptocurrencies are Revolutionizing Money The trouble is, cryptos are an immature technology at present and that fact may doom many of the current ones. Bernard Fickser looks at the “hard forks” where things went badly wrong. There are problems that decentralization and minimizing the need for trust can’t solve.

Part 5: Is cryptocurrency selling out to centralization? Crypto wealth is radically centralized in the hands of a few, compared to more conventional forms of money. A bit like the politician who goes to Washington to change things and leaves it unchanged — but has become a millionaire in the meantime…

and

Part 6: Why cryptocurrencies like Bitcoin are not ready for prime time Bernard Fickser at Expensivity — friendly to cryptos in principle — offers an unsparing look at the current problems. Unsolved problems include insane energy consumption, dead coins, and the potential of government subversion, if not suppression.