Three ways to make money trading cryptocurrency

HODL, day trading or market making? A professional investor knows how and when to use all three.

Three ways to make money trading cryptocurrency

Trading cryptocurrencies involves a certain amount of risk. But, as with anything in life, taking no risk means getting no reward. And trading crypto can be one of the more rewarding activities you've ever done! Not only can it be rewarding financially, but also in terms of acquiring new knowledge, putting it into practice and understanding how money works just a little bit better. Today, we're going to discuss three different ways you can make money trading on an exchange: buy-and-hold (colloquially called HODL), market making and active trading.

You can always trade cryptocurrencies directly between friends, but most effective trading happens on cryptocurrency exchanges. A good exchange is able to satisfy everybody's demands by providing enough liquidity on both sides of the trade (both buy and sell). The exchanges then ask for a certain fee from every trade that they keep as their profit and that hopefully encourages them to keep their product well maintained and secure.

Roles that a trader can play on an exchange

The fee structure of the exchange significantly impacts its prices and utility. This, along with the difference in liquidity and in market behavior between various exchanges and countries, is the reason why different exchanges have different prices.

bitcoin markets

Exchanges have different fees, rules, liquidity and prices

While there's a number of different ways an exchange could incentivise people to trade on it and extract fees, today most of the exchanges have converged on the maker-taker fee model. In this fee model the exchange establishes two roles for its traders: market makers and market takers.

Market takers are those people who come to the exchange and take liquidity from it. For example, when you buy BTC on one of the exchanges you take BTC from its order book.

Market makers are those people that supply the orders to the order book, and thus they bring liquidity to the market. There would be no trades happening on the exchange without market makers. In order to incentivise people to assume this role exchanges would typically charge a smaller fee to market makers, sometimes quite significantly so.

Now that we've covered the roles that you can play on an exchange let's discuss how to make money assuming these roles.

Buy and hold (HODL)

just hodl it

This is technically the simplest strategy of them all. If you have reasons to believe BTC, ETH, STN, or any other cryptocurrency is going to go up in price in the future you should simply buy this asset and hold on to it.

An efficient market ensures that this would be the cheapest way to make a profit from this information. Buying and holding brings higher returns per money and time spent than purchasing mining farms or any other strategy, provided that the purchased asset goes up in price.

This is also the most risky approach because it requires you to commit and take a certain side. Let's say you bought BTC and the price went up - good! But if the price went down you'll make a loss on this investment.

This strategy is preferential in volatile markets. All you need to do is wait the volatility out if you believe that the overall trend is positive. You also only pay the fee twice: first when you buy the assets, and then when you sell it and take the profit.

Market making

market making

Market making is a trading strategy where the trader simultaneously places both buy and sell orders in an attempt to profit from the bid-ask spread. Market makers stand ready to both buy and sell from other traders, thus providing liquidity to the market.

The strategy is appealing to traders because it doesn't require traders to take a directional view of the market - there's money to be made when the market goes up and when the market goes down. It's also heavily incentivized by exchanges looking for liquidity and volume - many exchange operators charge way smaller fees on their exchanges for market making activity.

Market makers typically make a fairly stable living by making a little bit of money on every trade, no matter whether the price goes up or down. However automated mindless market making may drain all your funds and leave you with nothing when an extreme situation happens and the market significantly moves in either direction. This strategy works best in markets with stable prices. In fact, in the traditional stock market, where a 2% dip is considered to be outrageous, market makers make such good money that they are typically heavily regulated and sign exclusive deals with stock exchanges.

Since it is a fairly simple strategy there's a lot of free trading bots that one can download and configure to perform market making on a wide variety of exchanges. Configuring them is usually not a simple ordeal and quite frequently requires knowledge of how to work with "the cloud" like Google Cloud, Microsoft Azure or AWS, as well as skills in information security and system administration.

Working as a market maker manually is best rewarded on new exchanges that do not have market making bots developed for yet.

Active trading

Two people in elegant shirts brainstorming over a sheet of paper near two laptops

Active trading is any other strategy that you perform on exchanges with the goal of making a profit. A variety of different financial instruments, such as futures, bonds, options and other derivatives allow finance professionals to control the tradeoff between risk and reward with very high precision.

The world of cryptocurrencies did not develop markets that are that efficient yet and most typical financial instruments are either unavailable, or are limited to only some individuals and organizations, or have very small market cap compared to the size of the market. However, there's a lot of money to be made by intelligently trading crypto! The catch is that you need to make your own indicators and your own hedging strategies that work in this new domain.

Unless you're actively trading your portfolio in order to minimize the risk of losing money (in which case cryptocurrencies are probably not for you yet), you would typically deploy a trading strategy that you've created that exploits some flaws in the market and demonstrates some "guaranteed" return, at least until the market corrects that flaws that make your strategy profitable. Such strategies are usually called arbitrage.

The simplest form of arbitrage is trading the same asset on different exchanges and making money on the difference between prices. For example, you buy BTC for $8000 on one exchange and then sell it for $12000 on another. If enough people are performing arbitrage they will eventually close the gap and will equalize the prices on both exchanges. Until such time there's money to be made in these transactions. In fact, this is the bread-and-butter strategy for traditional high frequency trading and is the reason why big investment firms want their servers as close to the centralized exchange as possible. However, this can be risky too, because if someone else executes their arbitrage faster than you, you might be left there holding an asset that you didn't really want to buy in the first place.

There are other types of arbitrage as well. For example, in the past we've pointed out that BTC's prices showed high intraday seasonality and we were able to make 15% returns in a market that crashed by 12%. This type of arbitrage is called statistical arbitrage and is the most elusive of them all. You are trying to find patterns in the market behavior by looking at the data from the exchange, social media and other data sources and then properly time the market in order to execute your strategy. Statistical arbitrage can make you a lot of money if you know how to cook it.

No matter what trading strategy you pick make sure that you're doing so responsibly and that you fully understand the risks you're taking. This way you'll feel better about yourself in case you lose money and you will be able to learn from this mistake. And in case you do make money, you will be able to learn from that too and learn how to make even more in the future.

Happy Trading!

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