In the dynamic realm of cryptocurrency trading, accurately calculating profits and losses is vital for effective financial management and regulatory compliance. Two widely used methods for determining the cost basis of cryptocurrency holdings are FIFO (First In, First Out) and Weighted Average. These approaches directly influence how much profit or loss traders report when they sell or exchange their digital assets, impacting tax obligations and investment strategies.
FIFO operates on the principle that the first cryptocurrency you acquire is the first one you sell, offering a straightforward and tax-authority-approved method. Conversely, the Weighted Average method computes the average cost of all your cryptocurrency holdings, providing a different lens through which to assess performance. Beyond these standard calculations, understanding how profitable trades are handled separately from the typical FIFO approach adds another layer of complexity and opportunity for traders.
FIFO Explained
FIFO, or First In, First Out, is an inventory accounting method where the earliest assets purchased are assumed to be the first sold. In cryptocurrency trading, this translates to selling the oldest coins in your portfolio first.
How It Works
Imagine you buy 1 Bitcoin (BTC) at $10,000, then another at $15,000. Later, you sell 1 BTC for $20,000. Under FIFO, the cost basis (cost basis includes the purchase price plus any associated costs such as transaction fees or commissions) is $10,000 (the first purchase), yielding a profit of:
- Profit = Sale Price – Cost Basis = $20,000 – $10,000 = $10,000
Advantages of FIFO
- Simplicity: FIFO is easy to understand and implement, requiring minimal calculation beyond tracking purchase order.
- Tax compliance: In some European countries the FIFO method is mandatory (Spain and Germany) or strongly recommended (Estonia and Sweden) with some also allowing the weighted average method if tracking is consistent.
- Falling markets: In a declining market, FIFO uses higher early cost bases, potentially reducing taxable gains.
Disadvantages of FIFO
- Rising markets: In a bullish market, FIFO assigns lower cost bases from earlier purchases, increasing taxable profits and tax liability.
- Limited flexibility: It doesn’t allow traders to strategically select which assets to sell based on cost.
FIFO’s clarity and acceptance make it a go-to choice, but its rigidity can be a drawback in certain market conditions.
Weighted Average Explained
The Weighted Average method calculates the average cost of all cryptocurrency holdings by dividing the total cost of purchases by the total number of coins owned.
Using the same example: you buy 1 BTC at $10,000 and another at $15,000, totaling $25,000 for 2 BTC. The weighted average cost per BTC is:
- Average Cost = Total Cost ÷ Total Coins = $25,000 ÷ 2 = $12,500
If you sell 1 BTC at $20,000, your profit is:
- Profit = Sale Price – Average Cost = $20,000 – $12,500 = $7,500
Advantages of Weighted Average
- Tax benefits in rising markets: By factoring in higher later costs, it can lower taxable profits compared to FIFO.
- Holistic view: It reflects the overall performance of your portfolio, smoothing out price fluctuations.
Disadvantages of Weighted Average
- Complexity: Calculating and tracking the average cost requires more effort, especially with frequent trades.
- Regulatory acceptance: Some tax authorities may not permit this method, limiting its applicability.
Weighted average offers flexibility and potential tax savings, but its complexity and regulatory uncertainty can pose challenges.
Comparing FIFO and Weighted Average
Both methods aim to determine cost basis, but their approaches diverge significantly:
- FIFO: Uses the cost of the earliest purchase.
- Weighted average: Averages the cost across all purchases.
Pros and cons side-by-side
| Aspect | FIFO | Weighted Average |
|---|---|---|
| Ease of Use | Simple and straightforward | More complex to calculate |
| Tax Implications | Higher profits in rising markets | Lower profits in rising markets |
| Regulatory Status | Widely accepted | Varies by jurisdiction |
| Market Suitability | Better in falling markets | Better in rising markets |
Choosing the Right Method
The decision hinges on:
- Trading strategy: Frequent traders might prefer Weighted Average for its averaging effect, while long-term holders may opt for FIFO’s simplicity.
- Market trends: Rising prices favour Weighted Average; falling prices suit FIFO.
- Tax jurisdiction: Check local regulations—some mandate FIFO, while others allow flexibility.
Consulting a tax professional is advisable to align your choice with legal and financial goals.
FIFO vs. Profitable Trades with Derivatives
As the FIFO (First In, First Out) method calculates your profit or loss based on the order in which you purchased your assets, it assumes that the earliest coins you acquired are the first ones sold. This method is widely used in spot trading, where you’re dealing with actual cryptocurrencies such as Bitcoin (BTC).
For example, if you buy 3 BTC at $10,000 each and later sell 1 BTC when the price is $12,000, FIFO says you sold the first BTC you purchased. Your profit would be $12,000 – $10,000 = $2,000, which you’d report for tax purposes.
Profitable trades with derivatives on the other hand are trades with derivative contracts that let you speculate on the price of a cryptocurrency (e.g., BTC) without owning it. Unlike spot trading, you don’t buy or sell the underlying asset. Instead, you open a position (long or short), and when you close it, you realize a profit or loss based on the price difference. These profits are typically settled in cryptocurrency or fiat and are treated as taxable income or capital gains, depending on your jurisdiction.
The key point? You can earn profits—like 2 BTC—without selling any assets you own. For tax purposes, these gains are still taxable events, even though no “sale” of your own holdings occurs.
- FIFO: Applies only when you sell assets you own (e.g., BTC in your wallet). It tracks the cost basis of those specific coins.
- Profitable trades with derivatives: Generate gains from closing derivative positions, not from selling owned assets. These profits are calculated based on the contract’s entry and exit prices, not your holdings.
Because perpetual futures profits don’t involve selling your own cryptocurrency, they’re treated as a separate taxable event from spot sales tracked by FIFO.
Case Study: FIFO vs. Weighted Average in Action
Alex, a crypto trader, buys:
- 2 BTC at $10,000 each on January 1.
- 2 BTC at $15,000 each on February 1.
On March 1, Alex sells 2 BTC at $20,000 each.
FIFO calculation
- Cost basis: $10,000 per BTC (first purchases).
- Profit: 2 × ($20,000 – $10,000) = $20,000.
Weighted Average calculation
- Total cost: (2 × $10,000) + (2 × $15,000) = $50,000.
- Average cost: $50,000 ÷ 4 = $12,500 per BTC.
- Profit: 2 × ($20,000 – $12,500) = $15,000.
Profitable trade with a futures derivative
Alex also buys 1 BTC at $2,000 and sells it at $3,000:
- Profit: $3,000 – $2,000 = $1,000.
- Calculated separately as a distinct asset, unaffected by BTC trades.
FIFO yields a higher profit ($20,000 vs. $15,000), increasing Alex’s tax burden. Weighted Average offers savings but requires more effort. The separate BTC futures trade, a clear profit, stands alone, showcasing how individual gains are tracked.
Conclusion
Cryptocurrency trading demands a clear understanding of accounting methods like FIFO and weighted average to ensure tax compliance. Adding derivatives trading into the mix increases the complexity of calculating realised gains accurately. FIFO is straightforward and widely accepted by tax authorities, while weighted average offers more flexibility and can reduce taxable gains in rising markets. Ultimately, the right method depends on the rules and allowances of your specific tax jurisdiction.
For tailored advice, it is always important to consult a tax professional together with a crypto profit calculator which can make the life of any advisor a lot easier.
