Understanding Crypto With Forex Trading
October 20, 2020
Buying cryptocurrencies can be compared to buying traditional currencies (fiat currencies) since both systems are based on the exchange of currencies and produce losses or gains based on their price fluctuation.
If I go to Japan and exchange 100€ for 12,400 yen I am carrying out a currency exchange operation. In the same way, if I buy 0.0097 BTC for 100€ I am still doing a currency exchange.
The main difference is that bitcoin, like other cryptocurrencies, is not a national currency.
Forex trading vs. Crypto trading
When we talk about trading traditional currencies we are referring to a specific market called Forex.
Both the cryptocurrency market and the forex market are decentralised. There is no authority at the head of this market and each broker offers a pair quotation strictly based on the current market price.
The abbreviation for “Foreign Exchange Market”. It is a decentralised and over-the-counter global market for currency trading. The Forex determines the exchange rates for each of them and includes all aspects of buying and selling.
Until a few years ago, before the explosion of the online trading phenomenon, Forex trading was the exclusive domain of large financial institutions, corporations and central banks.
In the early 2000s, the arrival of the Internet allowed small investors to enter the currency market through online accounts offered by specialised brokers. Today, small investors can also access the cryptocurrency market mainly through exchange services.
Understanding the mechanism behind Forex (buying and selling operations) will allow you to better understand the mechanism behind cryptocurrency purchases.
Online trading is the exchange of assets online for speculative purposes, i.e. to profit from the price change of an asset in the short or long term.
The mechanism behind forex trading is very simple: buying and selling currencies simultaneously. To each currency-purchase corresponds the sale of another.
Currencies are always exchanged in pairs – e.g. euros and US dollars (EUR/USD) – and the exchange takes place through a broker or dealer.
The same goes for cryptocurrencies, you buy one currency and sell another at the same time. This is why they are always exchanged in pairs, for example, BTC-ETH (bitcoin buys ethereum). Or BTC-EUR when you convert bitcoin into euro.
A pair of cryptocurrencies or fiat currencies consists of two currencies that can be exchanged for each other. A pair is written with the code of the two currencies, joined by a dash indicating their financial ratio (e.g. BTC-EUR). In a pair the first currency buys the second one (e.g. BTC-EUR = bitcoin buys euro, then I convert my bitcoins into euro). The BTC/EUR price, i.e. the exchange rate, informs traders how many units of quoted currency (EUR) are needed to buy one unit of base currency (BTC).
So let’s see a practical example of a trade on Forex.
From the Forex Markets page of any broker platform, let’s browse through the pairs list and choose the Euro/Dollar pair quotation that is valid today:
EUR/USD = 1,14107
- The currency to the left of the slash sign, in our case EUR (euro), is called the base currency;
- The currency on the right, in our case USD (US dollar), is the quote currency (also called secondary currency).
So, based on our example, to buy 1 euro I will have to pay 1.14107 US dollars. Vice versa, if I wanted to sell 1 euro I would receive 1.14107 US dollars.
Let’s now see the same example in a purchase and sale transaction on a cryptocurrency exchange.
I choose to buy bitcoins with Euro, so the BTC/EUR pair, and today BTC = 10.322,81 Euro.
To purchase 1 bitcoin, I have to pay 10,322.81 Euro. Vice versa, if I want to sell 1 bitcoin I will receive 10,322.81 Euro.
You don’t have to buy or sell 1 bitcoin. Just as the euro is divided into cents, in the same way, bitcoins and all cryptocurrencies can be divided into decimals. The smallest bitcoin fraction is 0.00000001 BTC (8 decimal places).
The same operation can be performed on any pair, from Euro to crypto and from crypto to crypto. For example, you could choose to buy ether with bitcoin (ETH/BTC pair), or Ripple with Euro (XRP/EUR pair).
Fees in crypto and forex trading
Certain elements must be taken into account when buying and selling fiat or cryptocurrency:
- Transaction fees
- The exchange’s spread
Like forex trading platforms, cryptocurrency exchanges also charge fees and a spread for certain trades.
The fees are used to repay the service offered by the exchange and the transaction costs on the blockchain, while the spread cushions exchange losses due to market volatility. The latter is the source of income for the exchange platform.
There are both centralised and decentralised exchanges. The former are more suitable for those who approach cryptocurrency for the first time, because they are services created by companies in the sector.
They help customers to solve technical and operational problems, offer a much simpler interface than decentralised platforms and provide additional services such as wallets.
Volatility in crypto and forex trading
Volatility is an element that, as we already know, affects all markets. For traders, volatility is the factor that actually generates profit (as well as potential losses).
In addition to being a measure of uncertainty, volatility is also related to risk. They are, in fact, directly proportional: the greater the distance between the price and the average value of an asset, the greater the risk.
Cryptocurrencies can reach very high price fluctuations, both positive and negative, such as -7% or +20% in 24h. For this reason, they are classified as high-risk assets.
The mechanism for generating returns with cryptocurrencies is based on a rather trivial principle: buy at a medium-low price compared to market standards and sell at a higher price.
For example, if I bought 1 BTC at 8,000 € and within 6 months the price increased up to 10,400 €, I could resell my bitcoins to receive 10,400 €, where 2,400 € is the yield (equal to 30%).
How to place a Purchase Order
Placing an order in the forex market is quite simple, many dealers offer a very intuitive interface.
Let’s take this case as an example:
- You decide to buy 1,000 EUR/USD at an exchange rate of 1.18. Your budget is automatically +1,000 EUR/-1,18 USD.
- After a while the exchange rate changes (due to volatility) to 1.25.
- You decide to exchange the 1,000 euros you bought: you want to sell them for a profit. Your balance will be -1.000 euro/+1.250 dollars.
Let’s recap the results:
EUR +1.000 – 1.000 = 0
USD -1.180 + 1.250 = +70
The earning from this position is therefore of 70 US dollars.
It may seem trivial, but this is exactly how you earn money by exchanging currencies, whether traditional or innovative.
Volatility is a percentage measure that indicates the distance of the price of an asset class from its average value. High volatility means more instability, more instability means more risk, more risk means more return or loss.
When volatility is high there will be more marked price fluctuations, while low volatility corresponds to a more linear price trend.
Let’s go back to the previous example on cryptocurrency.
- You decide to buy 300,05 euro of Ether (ETH/EUR). At that moment 1 ETH = 131, 05€
- So in the purchase summary, you will see the equivalent value in ETH of the 300.05 euros you are exchanging, in this case, equal to 2.1606 ETH
- Your budget is automatically -300.05 euro/ +2.1606 ETH
- After some time the ETH price changes (due to volatility) and reaches 1 ETH = 321.45 €.
- You therefore decide to exchange the 2.1606 ETHs in euros for a profit.
- Clearly, your balance is now -2.1606 ETH/ +694.55€, with a gain of 394.5€.
Volatility, despite being tied to risk and uncertainty, can therefore be an opportunity.
For this to be possible, you need to think long term by investing small amounts at different times, so that you do not have to wait for the perfect timing daily. Instead, you can act on a wider scale and on a longer period, so as to reduce the effect of fluctuations by even taking advantage of them.
For example, if you are willing to wait longer before selling, you might benefit from a bull market. If you want to read more about this technique, read “The warrior’s way strategy“.