Chapter 6

Trading Strategies

1. Trading vs. Investing

Trading is not to be confused with investing. Both practices have similarities, but their end objectives differ. The mechanics behind both practices consist of buying and selling financial instruments, such as cryptocurrencies, stocks, bonds, commodities, and more. Investing's end game is to create wealth throughout a long time by buying financial instruments. Storing bitcoin in a cold wallet is a great example of investing in crypto.

Traders are involved in more frequent transactions, regularly buying and selling to outperform the market and year-end profitability objectives. There is more greed in trading than investing. Investors expect annual returns above 10%; for example, traders seek the same return in a shorter period. If done recklessly, trading is riskier than investing because there is exposure to shorter timeframes.

2. How do Traders Make a Profit?

The golden rule for a long term strategy is sell high and buy low. A long strategy means that crypto traders expect the price of the cryptocurrency to rise in the future. Thus, buying cheap at the moment to later sell at a higher price. For example, Bitcoin is expected to be around $15k-$17k in December. Today bitcoin is worth $11k. An intelligent crypto trader would seize the opportunity and buy bitcoin to sell in December and profit from bitcoin's price appreciation.

What if bitcoin is to drop to $3k again in December? A short strategy should be implemented. When crypto traders short a cryptocurrency, it means that the price is forecasted to drop in the future. As a result, crypto traders borrow crypto from a broker and sell it at today's price with the obligation of rebuying the said crypto in the future, and returning it to the lender. It may seem confusing; that's why it is best to keep away short strategies until more experience is developed.

Both strategies, long and short, can be profitable. It all depends on the timeframe chosen. One week-long strategy may be the most profitable, but within a day of the week, short strategies reaped the most benefits. The market is moved by the everlasting clash between bulls (crypto traders using long strategies) and bears (crypto traders using short strategies). Eventually, one side wins, creating a trend.

3. Important Metrics

Performance

Performance may be the most exciting metric since it represents how much money was accumulated trading. In basic terms, the performance of a strategy is reflected by the percentage change of the trade. For example, Bitcoin was bought at $5,000 and is currently trading at $11,000. The performance of the long strategy, to this day, is 120%! Not bad at all! Getting an update of the strategy's performance is crucial because if the metric drops significantly, it may be time to reconsider the strategy or the crypto being traded.

Performance can also be used when deciding on what crypto to buy next. After looking at the performance of a cryptocurrency, one gets an idea of what may occur in the future. If bitcoin has outperformed throughout the year, it will likely continue to do so for the second half of 2020, and vice versa. Yet, the market can drastically change overnight.

It's always a good idea to compare the performance of the cryptocurrency using different timeframes, long-term, and short-term. For instance, if Bitcoin's performance is analyzed from a multi-year frame, it may seem that ever since its all-time high in 2017 the price has been dropping. On the other hand, every month Bitcoin has outperformed, rising 22.40% in July alone! Shorter time frames provide short term forecasts, so if Bitcoin is up 15% in the week after soaring 22.40% in July, it's very likely to see bitcoin continue rising. Depending on the crypto trader's objectives, a one-time frame may be better than the other, but it's highly recommended to analyze performance using yearly, monthly, weekly, and daily timeframes. This way, one can get a clear picture of what is expected in the future.

Figure 23 - 52.12% was the performance Year to Date for Bitcoin on August 25th, 2020
Volatility

Returns of 22.40% sound amazing, but there must be a catch. Well, there is a direct relationship between risk and returns: the higher the risk, the higher the potential gains. Volatility is one of the key metrics that describe the risk of a trade.

Volatility, in technical terms, is the statistical measure of dispersion of returns of a given crypto. Basically, volatility measures price deviation from the average price. Calculating volatility requires computing the average price and variance of the crypto in question. If the cryptocurrency moves up and below the average price aggressively, the more volatility.

Figure 24 - In 2020, volatility has reached similar levels as the peaks back in 2017

High volatility indicates big swings in price and low volatility represents stable price movements. Bear in mind that volatility is represented by an absolute value. Meaning that it does not provide positive or negative price movements. Therefore, the more volatility the harder it is to "predict" the outlook of the cryptocurrency.

Cryptocurrencies are well known for high volatility. It attracts investors due to its potential for higher returns and equal risk. It's best to compare the volatility of different crypto to determine the ultimate trade. For those risk-averse, seek crypto that are not as volatile. Currently, bitcoin has a very low volatility value, so it might be a good opportunity for a "safe" trade. Again, it all depends on the trading objectives and preferences. In times of uncertainty, its best to trade low volatility crypto. However, there's a risk of missing out on significant gains.

Market Cap

Market capitalization, or "Market Cap", must be considered when assessing the next trading strategy. Market cap represents the value of the cryptocurrency in the market by multiplying the circulating supply by the trading price. The higher the market cap, the bigger the cryptocurrency.

Usually, assets are divided into three market cap categories: large-cap, mid-cap, and small-cap. A crypto with a large market cap often represents a safer trade, since large caps are associated with well-known crypto that provides a constant stream of returns. Bitcoin has the biggest market capitalization at the time: $203,312,559,243. Seems logical due to the fact that bitcoin was the first crypto and is the most valued in the crypto market.

Market cap analysis is useful only if one decomposes the value by looking at supply and price separately. The best options are those that have average supply, but a high price that gives rise to a large market capitalization. When looking for new crypto to trade it is best to track its market cap. A steadily increasing market cap is always a sign of price appreciation.

4. Rules of Thumb

Like everything else, trading takes practice and time to perfect. With time trading becomes easier because one has discovered the rules of thumb. As a novice trader it's better to understand the rules of thumb before trading than to find out the hard way: by making mistakes that lead to losses...

1. Investing what can be afforded to lose

It doesn't matter how good the trade looks. Cryptocurrencies are extremely volatile and what seemed to be a good day can turn into chaos in a matter of minutes. Novice crypto traders make the mistake of using more money than what they can afford to lose. Patience is key for profitable trading. The best approach is to invest profits from previous trades before using cash to buy more crypto.

Using Dollar-Cost Averaging is the best way to create discipline. This responsible method consists of trading through periodic purchases. For example, imagine bitcoin is expected to rise (due to a bullish trend) for the rest of 2020, so every month, a trader will invest $200 (amount the trader can afford to lose) worth of bitcoin ignoring bitcoin's market price at the time of acquisition. This way the intelligent investor not only dilutes costs when bitcoin is more expensive, but avoids risking savings in one trade. This strategy serves best at volatile times.

A common mistake is to begin trading with margin. Margin trading consists of trading with borrowed funds, usually from the exchange itself. Yes, if the trade is right, margin trading can lead to substantial gains, but if the trade goes wrong... losses will bury previous profits. Avoiding trading with borrowed funds as a novice investor is the best way to begin trading. This way, losses are limited to the $200 that can be afforded to lose.

2. Assessing risk

Performance may indicate that the trade is great, but is it worth the risk? Risk assessment addresses this problem by determining the likelihood of a loss compared to the expected return of the trade. If the risk is higher than the expected return of the trade, it might not be worth the while.

There are different approaches to assessing risk. One can use volatility to determine the risk of the trade. Others include qualitative risks in their assessment. It's highly recommended to take as long as needed when assessing risk and to do quantitative and qualitative assessments.

Begin by analyzing the volatility of the crypto in question. Is it high compared to its historical record? What about similar cryptocurrencies? Is Bitcoin more volatile than Ethereum? If so, why is that and is the extra risk worth the while? Afterwards, it's suggested to do some research on current situations that might affect Bitcoin at the time, such as: geopolitical risks, macroeconomic indicators, scams related to Bitcoin, etc. Qualitative methods are more flexible because of subjectivity when coming up with conclusions. Finally, determine if qualitative risks can have an impact on volatility and bitcoin's price. The Fear and Greed Index is a good place to start.

The best trade is the one with the least risk and the highest return: low risk/reward ratio. Try comparing different risk/reward ratios between different trade options. The most efficient trade is the one that uses the least risk to get the highest return.

3. Objective and unbiased

Novice crypto traders get overly attached to their crypto trades if performance is high. Blinded by euphoria, they ignore the chance to close their trade and enjoy the profits. Instead, they are left waiting for more gains, and end up losing all that was gained by ignoring new trading options.

Being objective is key for profitability. Not being greedy, and knowing when to close the trade is crucial, but it takes discipline, especially when there are constant bull rallies. The best way to go about it is establishing profit targets: for example, as soon as bitcoin hits $12k the trade is closed. This way, one can secure the profits already gained without risking losing everything. Remember, past performance doesn't guarantee future performance. It's best to close the trade with profits than with losses.

4. Buying the dip

A dip is common in long-term bull runs (long-term price appreciation: bitcoin hitting $15k in Decem ber). It's unsustainable to have gains every day, because the crypto will become overbought and plummet. So using the Dollar-Averaging Cost strategy, already discussed, is key when buying small price retraces or dips.

Buying cheap is key to profitability. Buying bitcoin up +5% or +10% in the day may be risky because the price might drop for bitcoin to cool and continue rising. After a rally it is best to wait for the dip to repurchase bitcoin this way steep drops are avoided, and there's more room for benefits because it's known that Bitcoin can regain +5% or +10% once again.

5. Establishing benchmarks

A benchmark is a standard used to compare the performance of a crypto trade or portfolio. Establishing a benchmark for comparison is the best way to get an idea of the overall performance of the trade. Think of it this way: imagine the trade is down -5%. It seems like a bad trade, right? Now imagine that bitcoin, the benchmark, is down -10%. The trade's return doesn't seem that bad anymore .

It's important to set appropriate benchmarks because comparing different assets can lead to erroneous conclusions. Compare the trade to the crypto wished to outperform. If trading is limited to bitcoin and ethereum, it might be best to compare the farmer's performance to the latter. For example, let's say that the trade strategy consists of buying Bitcoin and Ethereum. The strategy has a return of 5%, while bitcoin's performance is 10% and Ethereum's 3%, then it's best to reconsider the strategy and trade Bitcoin without Ethereum.

6. Research and more research

There's a lot of hype around crypto, especially in social media. Crypto traders try to bait newcomers into their strategy. Some may be good strategies, but some can lead to losses. These sources of information should be considered as opinions that need confirmation. It's like buying something in Amazon: the product might look exactly to what you were looking for, but ignoring the reviews, specifications, etc might have repercussions.

Here are some reliable sources of crypto information that can be accessed online:

  • Coinmarketcap.com

  • Investing.com

  • Cointelegraph.com

  • Coinbase Earn

  • Binance Academy

When trading savings are at risk. Research is the only way to determine if bitcoin can continue outperforming gold, if volatility increases due to geopolitical tensions, and if bulls or bears are in command. Mitigate risk by conducting thorough research.

5. Basic Chart Interpretation

An analysis is crucial for determining the optimal trading strategy. Newcomers are discouraged from doing profound analysis because numbers can be boring and hard to understand. It's recommended to do some numerical analysis, but the focus should be on visuals.

Charts are the best visualization for trading and to review price levels, volatility, trends, and even performance in different timeframes. There are three basic charts that every crypto trader must know: candlestick, line, and area charts. The best type depends on the crypto trader. Nevertheless, one can be more useful than the other when looking for specifics.

Candlestick charts

Candle charts may be the most useful for traders because of the amount of information it provides in a simple and clean way. Candlestick charts are composed of green or red candles. Green candlesticks represent gains, and red candlesticks represent losses. Meaning that if the candle is green, it means the closing price is above the opening price, and viceversa. Candlesticks inform the trader about four important price levels: the lowest, highest, opening, and closing price.

Figure 25 - A gain followed by a loss is considered bearish vs. a red candle (loss), followed by green (gain) is bullish

The color and size of the candle are important because one can easily see if Bitcoin rose or fell and by how much. Candlesticks not only represent demand and supply action, but market sentiment through the size of the candle. If bitcoin's last candlestick is green and large, bitcoin soared! Looking at candlestick patterns is very useful to determine the upcoming trend. If three green candles follow a red candle, it means that the price is more likely to continue gaining. It's always worth looking for recurring patterns in the chart to get a picture of where Bitcoin is going.

Line charts

Line charts may be the easiest to use, but at the same time, they provide little information. They represent the closing price movement, so it's hard to see intraday (or weekly, monthly, yearly depending on the timeframe) price movements.

Figure 26 - A line chart can show the volum, price, etc over long periods of time

The clarity and easiness of the line charts make it great for newcomers, since novice traders may be overwhelmed with " paralysis of analysis." A lot of information crammed into one chart may be confusing and discouraging. Conclusions may vary depending on the amount of information analyzed. Line charts, therefore, are recommended for newcomers and not for those looking at high-frequency price action (hourly, minutes, or seconds).

Area charts

Area charts are very similar to line charts. They both connect closing prices with a line, but area charts connect the x-axis and the y-axis with a shade. This type of chart is very useful, because the larger the area the more pronounced the move. Area charts are handy when comparing performances between different crypto because the shades merge. The color that outshines represents the most profitable crypto for the specific timeframe.

Figure 27 - A stacked area chart allows you to compare the historical performance of different assets. It's always recommended to use different types of charts for analysis. One chart may be more useful for a specific metric, but others may be easier to understand, and get a clear picture of what is going on in the chart.
Super trend

A trend, in its simplest form, is a line that connects essential price points in a chart. The result of this analysis is the direction of the asset in question. If Bitcoin's trend is pointing upward (bullish trend) it means that price is expected to rise. On the other hand, if the trend is slanted downward (bearish trend) Bitcoin is expected to continue dropping.

Figure 28 - A super trend might provide you a long-term plan, but a shorter trend needs immediate action

When analyzing a chart, crypto traders may stumble upon various trends depending on the timeframe. The super trend, or the big trend, is the one that contains the short or smaller trends within it. For example, bitcoin may be undergoing a super bullish trend, but a short bearish trend is usually occurring. A perfect opportunity to buy. Begin with the super trend, because it's the easiest to discover. It usually is very obvious as it connects important price levels that stand out to the eye.

Volume

Volume is important because it confirms a trend, and reflects market sentiment when used with candlesticks. Volume measures the number of transactions within a timeframe (amount of times bitcoin was bought and sold in a day for example). To analyze the volume, crypto traders should begin by looking at spikes or big bars. These bars will usually be green or red.

Figure 29 - A volume trend is a secondary variable to confirm a performance-trend

If the bar is green, it means that most of the volume represents buying power, so it should be taken as a bullish sign. Red bars represent selling, so they are basically warning signs that crypto traders agree that Bitcoin's price is too high.

Volume is a good performance indicator because high levels show an agreement of market participants. For instance, when analyzing the super trend, look for high volume levels at the connecting points that are subject to the super trend. High volume levels also confirm new highs and lows. If a new high, represented by a green candlestick, along with a big green volume bar appears, it means that crypto traders agree upon that price value. On the contrary, a low is confirmed when a large red volume bar appears and is represented by a red candlestick.

Entry and exit points

A great way to mitigate risk and being objective is to establish entry and exit points. Like the super trend, entry and exit points are created by connecting price levels that represent a trading channel. A trading channel is represented by a resistance and support level. These levels are important because, as the price approaches them, it either reverts or continues on its way. Therefore, clear trading channels represent excellent opportunities to enter and exit.

Figure 30 - Support and resistance levels help indicate possible price trends in short periods of time

The golden rule consists of buying at support and selling at resistance (in a bullish trend or when bitcoin is rising), because it's very likely that bitcoin, for example, will trace back to retest support. Yes, Bitcoin may cross-resistance like a speed bump, but it's always better to establish profit targets to secure some benefits.

Be sure to confirm entry and exit points looking for big volume bars, and green candlesticks for resistance and red candlesticks for support. Never buy in the middle of the range because there is risk of retesting support before approaching resistance. Drawing resistance and support levels should be as easy as the super trend. The only thing required is patience and unbiasedness. Being bullish can lead to exaggerating resistance levels or optimistic support levels, and vice versa.

Remember trading takes time to perfect. Trading simulators are a great way to get started without risking savings. Get confident before joining the everlasting fight between bears and bulls. Trade safe.