Understanding the Various Ways to Invest in Bitcoin

Bitcoin LED sign
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Could you and should you invest in bitcoin? It's a tough question, and it depends on your appetite for risk.

Bitcoin is often touted as an electronic currency that will change the world, but it is also a highly volatile type of financial asset. In fact, many governments don't recognize it as a currency at all. In spite of the many merchants now excepting bitcoin, a lot of the activity surrounding bitcoin comes from traders hoping to make money on fluctuations in its value.

A Volatile Asset

Those fluctuations can be dramatic. In April 2013, the world gasped when bitcoins value jumped from around $40 the previous month to $140. By the end of the year, its value had spiked to more than $1000. At the time of writing, it has slipped back down in value to around $300 per bitcoin.

When there is fluctuation in a currency, there is lots of money to be made – and lost.

There are various ways to acquire bitcoin, although the simplest way to buy the asset in large amounts is to register with an exchange and purchase bitcoins using fiat currency.

Exchanges can be tricky, because many of them have proven to be highly unreliable, especially in the early days of bitcoin. Following the collapse of Mt Gox, one of the very first and largest bitcoin exchanges last year, things have started to improve in the exchange world.

Coinbase, which provides an online bitcoin wallet and was one of the earliest recipients of serious venture capital funding in the bitcoin world, launched its own regulated exchange in January 2015, targeting US users.

Over in the UK, Coinfloor is a bitcoin exchange based in the city of London, which lets users trade bitcoin using pounds sterling, euros, Polish zlotys, and US dollars.

Canada has seen two supposedly reliable bitcoin exchanges shutting their doors in recent times. Virtex shut its doors after user credentials were compromised, and the founders of Canadian exchange Vault of Satoshi closed their exchange, too.

Still standing is QuadrigaCX, based in Vancouver.

Buy and Hold

Many people invest in bitcoin simply by buying and holding the cryptocurrency. These are the people that believe in bitcoin's long-term prosperity, and see any volatility in the short term as little more than a blip on a long journey.

Long Positions

Some investors want a more immediate return, by buying bitcoin and selling it at the end of a price rally. There are several ways to do this, including relying on the cryptocurrency's volatility for a high rate of return, should the market move in your favor. Several bitcoin trading sites also now exist that provide leveraged trading, in which the trading site effectively lends you money to hopefully increase your return. Magnris one such example.

Short Selling

Especially during a bitcoin bubble, some people may want to bet on bitcoin's value going down. Short selling an asset involves borrowing the asset at a certain price ($100, say)so that you can sell it to someone else at the same price.

Then, should the asset decrease in value (let’s say to $50), you can buy it back at the lower price in order to give it back to your lender. You make a profit on the difference between the original price when you borrow the asset, and the lower price when you purchased it to pay back the lender.

You can short bitcoin via trading platforms like Bitfinex, which finds lenders willing to give you bitcoins for a certain period. You can also use derivatives trading sites.

Of course, there's always the danger that the market will move against you, and you may end up losing the money that you put up. Any trader should understand the concepts of leverage and margin calls before considering a shorting strategy.

Understanding Risk

It's important to realize that bitcoin is a volatile asset for a reason. It is still a relatively young asset, and even the trading platforms supporting it only matured to any significant extent in the latter half of 2014.

There isn't much liquidity in the bitcoin marketplace, relatively speaking, meaning that the volume of trading activity is relatively low. When liquidity is low, volatility is high.

Some of the giants in the bitcoin world also own significant amounts of the cryptocurrency, meaning that they can move the price relatively easily by trading large amounts in a short period.

All of this makes the market for bitcoins relatively irrational. Trading in irrational markets is dangerous because they can move against you for reasons that are hard to anticipate or even understand.

None of this means that you shouldn't invest in bitcoin, but it is extremely important that you know what you're doing, and that you don't invest more than you can afford to lose. It is considered a very high-risk investment, meaning that it should represent a relatively small part of your investment portfolio if you decide to invest at all.