A Guide to Start Trading Cryptocurrencies

Photo by Daniel Olah on Unsplash

There is a growing interest in cryptocurrencies and even more investors want to benefit from trading digital assets.

However, when talking to some of our clients at SmithBot, I found there are a lot of misconceptions amongst new cryptocurrency adopters on how things work in the crypto world.

In addition, there is a lot of information available on the internet, but it is not always beginner-friendly and all the required information for understanding the big picture is rarely in one place.

Therefore, I want to give you easy-to-understand explanations of the basic terminologies and processes behind trading cryptocurrencies on the spot market of an exchange. It is intentionally kept simple and no prerequisites are required.

What are Cryptocurrencies?

Most cryptocurrencies are decentralized electronic units that can be exchanged with other people without the need for middlemen. They are 'trustless', because there is no need for a trusted third party, such as a bank, for transferring ownership.

They exist in a blockchain on a distributed ledger and the cryptographic implementation and a network of validation nodes (e.g. miners) ensure the correct transfer.

Also, you have full control over your assets and no one else will ever have access to or control over your funds as long as they don't know your keys.

Storage of Cryptocurrencies

Crypto assets are stored in wallets. These are devices, programs or services that store the keys of your cryptocurrency transactions.

They come in different flavors, as hardware, software or web services, each with different advantages and disadvantages with regards to security, privacy, ease-of-use and costs. For an overview, click here.

Transfer of Cryptocurrencies

If you want to make a payment in cryptocurrency, you need to transfer a certain amount of it from your wallet to the wallet controlled by the receiver of the payment.

From your wallet, you can send cryptocurrency by entering the amount and the receiving wallet address.

The transaction is then broadcast to the net where it is validated following a defined procedure. After confirmation, a new block is written to the blockchain in the distributed ledger irrevocably documenting the transfer of assets.

The nodes in the cryptocurrency’s network confirming the transaction are sometimes referred to as the ‘miners’ (in particular in case of ‘Proof of Work’ consensus).

They will get some newly mint cryptocurrency as a reward for their efforts plus a network fee, you provide on top of the transfer amount.

The higher this fee, the higher priority you get in the network and the faster your transfer.

How are Cryptocurrencies Traded

Like many assets, cryptocurrencies fluctuate in value with respect to other assets and can be traded on specialized exchanges.

These exchanges maintain order books for each trading pair where buy and sell offers are listed. By accepting such an offer, an order is executed and your currency is exchanged to another currency.

Trading Pairs

Each cryptocurrency can be exchanged to another cryptocurrency or central bank money. The two currencies to be traded against each other form a pair.

For example, if Bitcoin is traded for US-Dollar, these two currencies are a pair. The currency that’s price is denoted in another one is called the ‘base’ symbol. The other one is the ‘quoted’ symbol. If the Bitcoin price is denoted in US-Dollar, such as 1 Bitcoin costs 40,000 Dollar, then Bitcoin is the base symbol quoted in US-Dollar.

The pair would be denoted as Bitcoin/US-Dollar (or BTC/USD in short) as the base symbol always comes first and the quoted symbol second.

Currency Symbols

In cryptocurrency and FOREX trading, each currency has an assigned 3 or 4-letter code. Some examples:

Order Book

The order book of a cryptocurrency exchange lists all the public buy and sell offers currently available for a certain pair at this exchange.

Each offer has a type ('buy' or ‘sell’), a rate (price) and a volume (the amount that is offered at this price). The last column shows the cumulative volume. Buy offers are also called ‘bids’ and sell offers are called ‘asks’.

In the screenshot above, an example order book from the Kraken exchange for the pair Bitcoin/US-Dollar is shown. The sell offers (asks) are in red, the buy offers (bids) in green.

The difference between the lowest ask (46015.6) and the highest bid (46015.5) is called the ‘spread’ (0.1 USD).

Orders

There are two basic type of orders: limit orders and market orders.

1. Market orders are executed immediately at the currently best available price in the order book.

   
   

   In the example above, a market buy order for BTC would be executed at 46015.6 USD (lowest ask) for a volume of up to 0.990 BTC. A market sell order for 46015.5 USD (highest bid) for a volume of up to 0.285 BTC.

   
   

2. A limit order is placed at a fixed price and shown in the order book, but there is no guarantee that it will be ever executed.

   
   

   It is waiting for a market order to match. The order book in the example above shows the open limit orders traders placed at that point in time.

   
   

If an order exceeds the available volume at the best price, it is split up into several partial orders. For example, given the order book above, you place a market order to sell 0.4 BTC.

Then, 0.285 BTC are sold at 46015.5 USD, 0.0007675 BTC at 46013.8 USD and the remaining 0.1142325 BTC at 46006.7 USD. Thus, the average sales price would be 46012.98 USD.

The difference between the best price and the real average price of your order is sometimes referred to as ‘slippage’.

Fees

Every exchange charges fees for their services.

These are usually subtracted from each order that is executed on the exchange and the amount is a fixed percentage of the order's volume. It depends on the order type and most exchanges have discounts for traders with high monthly trading volumes.

The fee for market orders is called the taker fee and the fee for limit orders is called the maker fee. The taker fee is usually somewhat higher than the maker fee, because the ‘market makers’ provide liquidity to the exchange whereas the ‘takers’ take liquidity out of the market.

Liquidity

Market liquidity refers to the ability of a market to absorb large orders without a large change in the price. As we explained above, when you place a large market order with a volume bigger than the available volume at the best price in the order book, this volume at this price point will be ‘consumed’ and you continue to consume the volume in the order book at the next price point and so on until all your volume is filled.

Thus, the best price (lowest ask for buy orders or highest bid for sell orders) is moving towards more unfavorable prices.

In a market with high liquidity, there are many limit orders with high volume and tightly spaced prices in the order book. Therefore, a large market order will not move the best price a lot and slippage is minimal.

In a market with low liquidity only few limit orders with low volume and larger price distance are in the order book. Thus, a large market order will have a significant impact on the price and large slippage is expected.

What is a Trading Bot?

Tradings bots, such as the ones provided by SmithBot, are essentially computer programs or virtual agents that automate trading at a cryptocurrency exchange.

They are constantly fed with real-time data about the market or related events and decide based on a set of arbitrarily complex rules (the algorithm) when to place an order at the exchange.

The goal of trading bots is to generate positive returns, aka profits. The ruleset of a trading bot can be defined manually based on empirical or heuristic considerations or, as is the case with SmithBot’s AI-engine, learned from large amounts of data.