Bitcoin, often featured in financial news for its dramatic price swings and potential rewards, remains a mystery to many people, including retail investors. In the UK, a significant portion of the population still doesn't fully understand what bitcoin is or how it works. This guide aims to demystify bitcoin, covering the basics to help UK-based personal traders understand the cryptocurrency and financial asset better and to make informed investment decisions.

Bitcoin, created in 2009, is the world's first decentralised cryptocurrency and remains the largest by market capitalisation. Unlike traditional currencies issued by governments (fiat currencies), bitcoin is a digital currency that operates without a central authority. Transactions are peer-to-peer, meaning they occur directly between users without intermediaries like banks. It does so successfully by using innovative cybersecurity and transaction validation methods that circumvent the need for a central party.

Bitcoin exists as a digital file stored in a "digital wallet," which can be accessed through a smartphone or computer application. These wallets allow users to send and receive bitcoins. Each transaction is recorded on a public ledger known as the blockchain, a secure and transparent system that tracks all bitcoin transactions.

Unlike the traditional monetary system, there are no central banks or governments that control bitcoin. No single entity controls it. Rather, it is maintained by an open-source software community. The bitcoin network is decentralised, relying on a consensus protocol to validate transactions and secure the network. Users interact with the network using various software versions, but the fundamental process of sending and receiving bitcoins remains consistent.

Bitcoin transactions are secured by advanced cryptographic techniques, making the network robust against many types of cyber attacks. However, risks remain, such as price volatility, potential hacks on digital wallets, and the use of non-secure third-party services.

If using offline wallet storage, another risk is misplacing or damaging the wallet, or forgetting the password to access it. Like any investment, understanding these risks and how to protect against them is crucial for traders.

There are several ways to acquire bitcoin:

1. Purchase with traditional currency: You can buy bitcoin on various cryptocurrency exchanges using GBP or other fiat currencies.
2. Mining: This process involves using computer power to solve complex mathematical problems, validating transactions, and generating new bitcoins.
3. Goods and Services: Accepting bitcoin as payment for goods or services is another way to accumulate the cryptocurrency.

Bitcoin offers several potential benefits for personal investors:

• High Returns: Bitcoin's price volatility presents opportunities for significant gains, though it also poses substantial risks.
• Diversification: Bitcoin presents an alternative kind of financial asset to more traditional asset classes, like stocks and bonds.
• A hedge against inflation: Bitcoin investment may offer an opportunity for hedging inflation risk.
• Speed and Efficiency: Bitcoin transactions are typically faster and cheaper than traditional bank transfers, as they do not require bank clearance.
• Decentralisation: Being free from central bank control, bitcoin allows for more freedom in transactions.

Trading bitcoin carries several risks that personal investors in the UK must consider. Price volatility is a significant concern, as bitcoin prices can fluctuate dramatically within short periods, leading to substantial potential losses. Regulatory risk is also important; changes in government regulations can impact the legality and value of bitcoin. Security risks are ever-present, with digital wallets and exchanges being potential targets for hackers, which could result in the loss of your investment. Market manipulation is another issue, with the relatively unregulated nature of cryptocurrency markets making them susceptible to manipulation. Additionally, technical risks such as software bugs or network attacks can disrupt bitcoin transactions.

To mitigate the risks associated with bitcoin trading, consider the following strategies:

1. Diversify Your Portfolio: Don't put all your investment into bitcoin. Spread it across different assets to reduce risk.
2. Use Reputable Exchanges: Trade on a well-established and regulated UK-based cryptocurrency exchange to minimise security risks.
3. Enable Security Features: Use two-factor authentication and other security measures to protect your digital wallet.
4. Stay Informed: Keep up-to-date with regulatory changes and market trends to make informed decisions.
5. Set Stop-Loss Orders: Use stop-loss orders to automatically sell your bitcoin if its price drops to a certain level, limiting potential losses.
6. Consider Professional Advice: Consult with financial advisors who are knowledgeable about cryptocurrencies to guide your investment strategy.

In the UK, bitcoin is legal and can be used to buy goods and services or traded like a commodity. However, it's important to note that profits from bitcoin trading are subject to capital gains tax. Always stay updated with HMRC guidelines to ensure compliance with tax obligations.

Bitcoin's future is a topic of much speculation. Many financial commentators believe that digital currencies will become more mainstream as technology evolves and people become more comfortable with digital finance. The financial industry is gradually embracing cryptocurrencies, with some investment advisors already including them in their clients' portfolios.

For UK personal traders, understanding the basics of bitcoin is the first step towards making informed investment decisions. While bitcoin offers significant potential rewards, it's essential to remain aware of the associated risks. As with any investment, thorough research and caution are paramount.

For more information on trading and investing in bitcoin, and cryptocurrency investment more broadly, browse the OANDA Crypto blog for UK retail investors.

Disclaimer

Don’t invest unless you’re prepared to lose all the money you invest. This is a high-risk investment and you are unlikely to be protected if something goes wrong. Take 2 minutes to learn more.