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Buying Bitcoins from a Currency Exchange

Currently, no clear front-runner exists among the Bitcoin currency exchanges. Therefore, the following are general steps that you should apply to any Bitcoin exchange.

Step 1: Setting Up an Account and Linking to Your Bank Account

The first steps when buying bitcoins on an exchange are identical to the steps you used with Coinbase: Go to the exchange's website, create an account, and then connect it to your bank account. Some exchanges cannot be directly linked to your bank account and instead require you to send money via a bank wire or another method.

Step 2: Transferring US Dollars to Your Exchange Account

Bitcoin exchanges are different from exchange intermediaries in that they don't transfer the dollar equivalent from your bank account. On these sites you first need to transfer just dollars to your exchange account before you can turn them into bitcoins.

Step 3: Placing an Order to Buy Bitcoins

Once you've funded your exchange account with bitcoins, you can participate in the exchange market by placing an order for bitcoins. Usually, an exchange site will let you enter two types of orders: market orders and limit orders. Let's explore the properties of each order type so you can determine which is right for you.

Market Orders

By placing a market order, you specify that you want to buy bitcoins immediately at the best price currently available. The advantage of market orders is that they are executed quickly, so you won't have to wait for your bitcoins. Closing an order quickly is valuable if you have reason to believe the price will soon increase.

However, market orders have several important shortcomings. First, because you're specifying that you'll take any price to obtain your bitcoins quickly, there is always a rare chance the Bitcoin price might exhibit a momentary spike, forcing you to pay a much higher price than expected.

Second, if a commodity (any commodity, in fact) is traded at a low volume, it usually will also have a large spread, which is a large gap between the current best buy price and best sell price. Traders commonly make a guess as to the fair value of a commodity by taking the average of the buy and sell prices. If a commodity has a large spread, the price you'll pay at a market buy price will be significantly higher than the theoretical true price. Therefore, you should use market orders only for commodities that are traded at a high volume, which would have a small spread. For the most part, bitcoins have a relatively high volume at the large exchanges. So you might be satisfied paying this small premium for your bitcoins in exchange for getting your coins immediately.

Another more nebulous risk with market orders is that they make it possible for your order to be manipulated if another person learns about your order ahead of time, even if only by milliseconds. An outside person, a person inside the exchange company, or even the actual company that knows about your order in advance could buy some coins before your order is processed and then resell them to you at a slightly inflated price.

Surely you've heard about the recent high-frequency trading shenanigans on Wall Street, some of which involved similar tricks with market orders.

Limit Orders

To buy bitcoins with a limit order, you specify that you don't want to pay more than X dollars for each bitcoin and that you're willing to wait until you can get this price. Typically, you'll name a price lower than the current market price for bitcoins; then you'll wait for the price to drop to your price target. The risk with a limit order is that if the price of bitcoins keeps rising nonstop after your order is placed, your order will never execute. However, usually enough small market fluctuations occur in the Bitcoin markets that most limit orders with a limit close to a recent trade price will be successful.

Despite the extra time involved in obtaining your coins and despite the fact that your order may never be executed, a limit order has more advantages than a market order. For this reason, if you can wait to get your bit-coins, it's best to always use limit orders.

One advantage of using limit orders is that you won't be surprised by an unexpectedly high purchase price because you're the one who gets to decide on the ceiling for the price. Another advantage is that you can get a decent price, even if the trading volume on the exchange is low (with a large spread). Still another advantage is that other parties have more difficulty manipulating limit orders.

One final advantage is that limit orders are considered market-making orders by the operators of the exchanges. In essence, this means limit orders narrow the spread of a commodity by putting a new price on the table, whereas market orders widen the spread by eliminating prices. Although most current Bitcoin exchanges charge identical fees for market and limit orders, in other financial markets, limit orders often are available at a discount due to the benefits they offer the exchange operators. Therefore, in the future it is likely that Bitcoin exchanges will offer special discounts for limit orders on bitcoins as well.

 
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