There’s endless media stories about how many new and young millionaires the crypto market has created.
While crypto isn’t new (it’s been around in some form since 2009 with the advent of Bitcoin), it’s only reached the high level of mainstream appeal since 2020.
As such, you can hardly go to a bar and not overhear a group of young men talking about their crypto gains, or how to get into the market. It’s hard to overstate how much FOMO and enthusiasm surrounding this brand new asset class.
Institutional money is finally starting to pour in and the big prop trading firms are hard at work developing algorithms to take advantage of arbitrage opportunities that haven’t been present in the equities markets since the 1990s.
Many of us stock traders have adapted and started taking advantage of the volatility and volume, however, due to custodial, tax, or skeptic-related concerns, many are late to the party and confused where to start.
The Stage of the Crypto Market
Joel Rubano, author of the Trader Construction Kit, is fond of saying that there are several different stages that markets go through, and each stage has separate players, average levels of expertise, and priorities.
These stages are:
- Early Stage
- Early-Middle Stage
- Middle Stage
- Middle-Late Stage
- Late Stage
For example, US equities are a late stage market. All of the very obvious arbitrage strategies are impossible without millions of dollars of infrastructure.
Nearly every mechanical strategy under the sun is being traded in some form. Transaction costs are very low, and the average player in this market is highly knowledgeable about the asset class.
I think most would call the crypto market an early-middle stage market.
This stage is marked by the first entrance of institutional banks and traders, the development of derivatives, and a significant increase in credit exposure.
As a result of the vastly different stages that stocks and crypto are in, that alone is enough to approach crypto with a clean mind and a respect for the differences.
Market Structure
The US equity market is pretty centralized.
Sure there’s dozens of stock exchanges, but each one of them has to abide by the same strict SEC regulations, so the differences, so long as you’re not a high-frequency trader, are minute.
On the other hand, there’s virtually unlimited crypto exchanges, some of them shady and offshore, and each of them can set their own rules. Regulations, compared to the rest of the financial markets, are almost nonexistent.
Furthermore, the stock market is only open from 9:30 to 16:00 while crypto is open 24/7.
As a result, the same U-shaped intraday volume distribution isn’t present in crypto as it is in the stock market due to the elevated volume at the open and close.
The derivatives crypto traders prefer differ too. The volume and liquidity in non-expiring perpetual swaps far outweigh that of futures contracts.
And the entire market structure problem is compounded when we arrive at the biggest structural difference between stocks and crypto: the exchanges.
You see, the SEC created something called the National Market System (NMS) for the US stock market to encourage exchange competition. This linked all of the exchanges together so that when an investor wanted to buy 100 shares of General Electric, his order was routed to the exchange with the best price.
This “best price” is known as the National Best Bid and Offer (NBBO) in the stock market and there are stiff punishments for licensed stock brokers to fill a customer order at a worse price than the NBBO.
The crypto market does not have such centralization of exchanges. That’s kind of the whole idea of it; decentralization.
So there are hundreds of crypto exchanges and it’s not a trivial task to automatically route your order to the exchange with the best price.
Why? Because the crypto exchanges also act as your broker/custodian for crypto, meaning they’re not eager to route order flow away from their own exchange.
For this reason, crypto traders tend to trade on the exchange with the most liquidity, rather than the one which most frequently has the best prices or fees. As Scott Patterson says, “liquidity begets liquidity.”
Valuation and Pricing Mechanisms
FinViz’s database has over 8,000 publicly-traded US stocks.
There’s several thousand more traded over-the-counter. Many are shoddy penny stocks, and some are predictable and mature businesses that pay above-market-rate dividends. Others are turnarounds; the disrupted business of yesterday which may still have a fighting chance with new management. We have growth stocks and value stocks, quality stocks and momentum stocks.
Differences aside, stock prices are a reflection of investors perceptions about the value of future cash flows.
Some stocks are valued very precisely by breaking down every facet of the business through complicated models. Others are simple consumer businesses requiring back of the envelope math. And then there are those which are valued almost completely on tomorrow.
Think of all of those zero-revenue companies in the dotcom that got multi-billion dollar valuations–those were based on some loose projections that the internet was going to disrupt entire industries within years.
Rarely will a mature business in a low-growth industry trade at, say, 100x earnings (okay, unless there’s a historic short squeeze destroying a few hedge funds in the process). There’s a grounding mechanism to the price of a stock.
The economics and regulations of the airline business doesn’t allow an airline to re-rate their multiple from 8x earnings to 50x earnings like a software company.
Cryptocurrencies, on the other hand, have no grounding mechanism for their price.
Price Action
Once you have a basic technical understanding of how the crypto market works, and your place within it, the price action differences are the primary differentiating factor between it and the stock market.
No Long-Term Drift
US stocks have a long-term upward drift, mostly owed to the staggering growth of the US economy coupled with technological innovation.
All factors aside, having a long bias when trading stocks is an edge in itself. See below the slightly skewed daily return distribution of the S&P 500:
Needless to say, all of this analysis is backward-looking and makes the questionable assumption of continued long-term US economic growth and dominance. But history is really all we have.
On the other hand, there isn’t nearly enough long-term crypto data to suggest that there’s a long-term drift in either direction. Furthermore, there isn’t a common-sense reason to suggest such, either.
Long-term stock returns are strongly correlated with earnings growth, which is correlated with GDP growth. Back-of-napkin math can explain the returns.
However, the explanation of crypto returns is far more abstract and hand-wavy. Growing or waning skepticism of the US dollar and fractional reserve banking, the growth of computing power, growth of respective crypto networks, etc.
These are financial assets and don’t have a concrete financial reason to explain their returns.
Ownership
Many crypto traders live by the mantra “not your keys, not your coins.” If you’re storing crypto on an exchange, you don’t exactly have strong legal ownership over them as you would holding shares of stock in a brokerage account.
As such, there are few practical custodianship issues in the stock market, while this is still a huge obstacle for institutional and retail traders alike in the crypto world.
Even if traders keep custody of their own coins, the keys could still get stolen or destroyed, which is near impossible in the stock market.
Furthermore, it’s clear what you own when you buy a stock. A percentage ownership of a real company. But most crypto coins don’t actually give you an ownership stake in the platform itself. They’re instead coins with a specified use and their market price varies based on the perceived value of that use.
The Price Action of Altcoins
Besides the “blue chip” coins with multi-billion dollar market caps like Bitcoin and Ethereum, the price action of most crypto coins resemble that of a low float momentum stock. The current trading population of these are similar as well:
- Insiders/promoters who are in on the scheme before the rest of the market
- Day traders who trade purely for momentum
- The suckers who buy into the promotional story
The psychology of the average participant in one of these coins is drastically different from that of the average Bitcoin trader. There’s market manipulation, cynical traders looking to make a quick buck even though the ultimate fate of the coin, misguided ruses who fall for the scam, etc.
There’s also the mutual issue of low liquidity in both low floats and smaller altcoins.
While in Bitcoin, you have some of the same characters but at a far smaller scale. Most of the trading volume is made up of market makers and institutional trading now, making the price action more choppy, giving trends far less follow-through.
The Similarities Between Crypto Trading and Stock Trading
Many technical analysis books love to claim that you can apply the same principles to any tradable security. The same setup you use to trade General Motors stock could be theoretically applied to trading German electricity futures contracts.
That’s obviously wrong, as anyone with a modicum with trading experience learns. But I think there’s a grain of truth there. If you can identify the dominant market regime, you can apply one of a few static trading styles to a market, rather than applying the same principles to any asset class.
For this reason, you can use many of the same technical trading strategies that you use to trade stocks on crypto coins. You just have to ensure you’re applying appropriate strategies for the market regime. In other words, don’t try to be a trend trader in a range-bound market. Don’t play for follow-through if trends in a market tend to be short-lived, and so on.
So without further or do, here’s a short list of some of the dominant similarities between the crypto and stock markets:
- Both are continuous auction markets
- Most crypto exchanges use a central limit order book and order matching algorithms, as the stock market does.
- The price action of the more speculative lot of crypto coins is quite similar to that of penny stocks.
Bottom Line
There’s no guarantee crypto will be around in a meaningful form 10 years from now.
The industry is fraught with uncertainty and risk.
But with high risk often comes high potential returns, and if you follow some crypto people on FinTwit (financial Twitter), you’re fully aware of how stupendous the potential returns are compared to even spectacular years of trading stocks.
Without a doubt, moving into crypto as a stock trader is daunting and show it the respect it deserves.
The industry is full of tech geniuses, both trying to fix complicated tech problems, and genius traders taking advantage of the inefficiencies present in crypto markets that are no longer present in stock trading.
The post The Similarities Between Crypto and Stock Trading appeared first on Warrior Trading.
