Cryptocurrency turned from a niche thing known to a small group of computer geeks into a wildly popular speculative asset class that requires a number of trading tools and options. Contracts for difference – or CFDs for short – have been a favourite instrument for trading anything from gold to soybeans for decades, and now CFDs are widely used to speculate on cryptocurrency price movements.
Let’s take a closer look at what CFDs are and how they can be used to gain exposure to the cryptocurrency market.
What is a CFD?
A contract for difference (CFD) is a financial derivative made in the form of futures contracts concluded between a trader and a broker and settled in cash payments rather than by the delivery of physical goods or assets.
Basically, CFD traders do not actually deal with the underlying asset. Instead, they get the right to receive the difference between the current cost of an asset and its future value. If traders are right with their predictions of the asset’s future value, they pocket the price difference. Otherwise, they have to cover the loss by paying the price difference to the broker. This system works nicely for any type of asset, including cryptocurrencies.
Let’s say you are sure that the price of Bitcoin will rise substantially soon and you want to profit from that price movement. You may go out and buy some coins at a cryptocurrency exchange, but the procedure is pretty tiresome and sometimes complicated, especially when your investment horizon is only a couple of hours and you are not experienced in dealing with digital money. In this case, you can opt to buy a contract for difference instead of purchasing real Bitcoin.
Most of the major trading companies have already responded to the growing interest in crypto trading and added CFDs for various digital assets to their lists of tradable instruments. It means that you won’t have problems finding a broker with suitable trading conditions. For example, you may sign a contract for difference with any other trading company at a current price with the settlement at the end of the business day.
If you got it right about the future price movements and Bitcoin grows higher within the lifespan of the CFD, the broker pays you the difference. On the other hand, if your forecast proves to be wrong, you lose money as you have to compensate the price difference to the broker. Basically, you bet on whether the price of the asset will drop or rise within a specific time. As neither you nor your counterpart has to own actual Bitcoins to do that, a contract for difference offers investors a hassle-free and straightforward way to generate profits on changing cryptocurrency market conditions.
Advantages of cryptocurrency CFD trading
A lot of traders seek cryptocurrency exposure with established brokers via CFDs as this type of investment option has various benefits over direct buying and selling of cryptocurrencies.
Direct cryptocurrency trading is often associated with technical issues. People who are not tech-savvy are sometimes scared by wallet opening procedures, a verification process on a cryptocurrency exchange, and other crypto-related nuances. They tend to resort to exchanges with a long experience of customer relations, easy account set-ups, and one-click trading features. Also, those engaged in CFD trading for other products are more likely to use this instrument to add cryptos to their existing portfolio of CFDs and benefit from their price movements.
Access to high leverage opportunities is probably the most popular reason for trading cryptocurrencies via CFDs. This tool allows trading with more capital than a trader actually has. It means that with a 5:1 leverage, you need only $500 to open a position worth $2,500 and earn a considerable profit even with small price movements. As regulatory requirements towards digital assets do not bind brokers, they are free to decide on how much leverage to offer. That is why margins on CFDs are usually higher than on futures contracts or the underlying asset. However, leverage increases both earning opportunities and potential losses, which means that one needs to be extra careful when trading CFDs for cryptos with leverage.
Leverage is offered by the vast majority of brokers, while most cryptocurrency exchanges – apart from BitMEX, Kraken, and Poloniex – do not support this option.
Advanced technical instruments
When trading CFDs for cryptos with a traditional broker, you have a wide choice of technology and risk management instruments at your disposal, including stop loss and take profit tools. Considering the notoriously high volatility of the cryptocurrency market, they may come in handy and protect you from devastating losses. At the same time, advanced charting tools and analytical support offered by brokers help to make informed investment decisions and improve your overall performance.
Most CFD brokers are regulated by CySec, the FCA, or some other reputable financial watchdog. It means that customers of a trading company are better protected from fraud, bad practice, and outright theft. Moreover, in the event of bankruptcy or other similar adverse circumstances, traders may apply for compensation and get all or some of their money back.
Speed of trading
As you do not actually buy or sell digital assets with a CFD, all your transactions are executed in a split second on the broker’s trading platform. This gives you flexibility and allows you to react quickly to market movements. Meanwhile, cryptocurrency transactions on the blockchain may take hours and even days depending on the coin and the network capacity, which means that traders won’t be able to benefit from rapid market changes.
Still, nothing is perfect. Could CFDs impact traders and investors negatively?
Disadvantages of cryptocurrency CFD trading
For all the benefits described above, CFDs for cryptocurrencies have two major drawbacks and pitfalls worth considering before putting your money into one.
CFD crypto trading comes with a price in the form of a spread, which represents the difference between the buying and selling prices. You pay it anyway, irrespective of the outcome of the trade, so you will initially experience losses at the time you enter into a crypto CFD position. The less liquid and riskier an underlying asset is, the wider the spread you pay.
As well as this, all CFD brokers charge fees for holding a CFD position from one day to the next. They are based on a percentage from the LIBOR rate and may be really high for Bitcoin and other cryptocurrencies due to their volatile nature. As a result, the expected price movement should be significant to cover the trading commissions and bring profit.
CFDs are based on a significant amount of trust. You need to make sure that the prices on your broker’s platform are in sync with general market movements and sourced from an exchange. Some unfair brokers may manipulate the cryptocurrency prices which might lead to unnecessary losses on clients’ accounts. Moreover, some CFD brokers have already shut down cryptocurrency trading, which makes them less reliable in terms of continuous service.
Disclaimer: The views and opinions expressed by the author should not be considered as financial advice. We do not give advice on financial products.