Once hailed as a step toward institutional adoption, crypto-backed derivatives, contracts and other financial instruments are almost commonplace now. In this guide, we define one of the most long-standing instruments that helped cryptocurrencies find notoriety in the finance and trading world: the CFD.
What is the meaning of a cryptocurrency CFD? How is trading CFD vs directly crypto different? This and more will be answered by this guide!
Key Takeaways
- Cryptocurrency CFDs are Contracts for Difference that track crypto assets. Contract for Difference is a financial instrument that lets traders and brokers arrange an agreement to essentially bet on price movements of the underlying asset.
- CFDs do not require any party to hold the underlying asset, do not expire, and enable leverage to amplify both gains and losses. Other risks of CFDs are shaky regulatory status that requires trust in the broker and liquidation risks in volatile markets.
- Beginners are better off engaging in less complex and more regulated modes of trading before trying contracts. If a trader still wants to trade CFDs, it is advised to get a handle on accompanying risk management strategies beforehand.
What are CFDs?
Definition of Contract for Differences (CFD)
Before we define what crypto CFDs are, it’s useful to get to know or refresh what a CFD is. It stands for “contract for differences”. With CFD, an arrangement is made to pay the difference between the opening price at the time of agreement and the closing price in cash.
Essentially, traders make bets whether the price of an underlying asset will rise or fall.
By their nature, CFDs are contracts. You can trade other assets, derivatives and even contracts (e.g. futures) through a CFD. They trade similarly to securities with a buy-and-sell price and have no expiry date.
If you are knowledgeable about trading and markets, here are a few more characteristics of these contracts that can help you understand them:
- Unlike futures and options contracts, CFDs have no expiry date.
- Unlike perpetual contracts, CFDs specify a buy or sell price.
- CFDs are traded over-the-counter and on margin (i.e. with borrowed funds).
How Does CFD Trading Work?
Source: FXSSI
How would a crypto CFD work? Let’s say, Alice wants to open a buy position on BTC because she believes it can rise to $115,000. Bob, who is a broker, requires 5% of the trade for his services. Through him, Alice opens a $25,000 position when BTC is trading $100,000 a piece. Out of it, 5% or $1,250 is paid initially to Bob. Alice pays $26,250 in total.
A month later BTC is trading at $115,000, and Alice closes her position, which now is $28,750. The CDF is cash-settled, the initial position and the closing position are netted out. The gain of $3,750 (the difference between $28,750 and $25,000) is credited to Alice, and her total profit is $2,500.
From this example, you can see that Alice did not need to buy or hold Bitcoin directly. She only made a bet on its price. It means she did not need to pay any associated fees nor risked losing access to her wallet at any point. CFDs also allow fractional ownership, which is not a big deal in crypto but can definitely change the game in other markets. Moreover, she could have made a bet on Bitcoin losing value but still profit from it. These are the advantages that make CFDs popular with traders.
However, this mode is not without its disadvantages. Bob the broker has taken a portion of Alice’s profits with his fee, and the more volatile a market is, the higher the spread between bid and ask prices. CFDs are only suitable for trading but not holding, long-term strategies. Last but not least, it should not be hard to arrange in the Bitcoin/USD market but other combinations of currencies may be a no-go for a CFD.
In our example, we also did not go deeper into adding leverage to the equation. Leveraged trading means funds are borrowed to increase the position size and amplify both losses and gains. Naturally, this directly influences the risk/reward ratio.
What are Crypto CFDs?
Source: Bitcoinwiki
Definition of Crypto CFDs
So what are crypto CFDs, then? These are contracts to trade cryptocurrencies as an asset tracked in the CFD. In this case, crypto CFD meaning would be betting on a movement of a crypto/crypto or crypto/fiat trading pair, such as Bitcoin/EUR or Ethereum/Bitcoin.
Just like in a regular market, trading a cryptocurrency-tracking CFD is not the same as trading the asset itself, like you would do on a spot market. As the name suggests, you only make a contract with a broker that tracks a specific crypto market. At no point it is obligatory you hold it directly.
Crypto CFD can be traded on the majority of OTC desks that offer cryptocurrency trading. It is very likely that there is at least one available in your region: Markets.com, XTB, eToro, Plus500, AvaTrade, CMC Markets and others. The choice is usually more limited than on centralized exchanges but you can still reasonably expect to find dozens of crypto asset CFDs beyond ones for Bitcoin and Ethereum.
Advantages of Trading Cryptocurrency CFDs
- Access to the underlying asset for only a fraction of the price. You do not need to buy an asset outright but get the full profit (or loss) from your position.
- Moreover, in a CFD you do not actually have to buy cryptocurrency at all. No problems with exchanges, transfers and keeping the digital coins.
- With CFDs, traders can go both long and short, while it is not always possible with spot trading. When we talk about betting on growth, it is a long position, and shorts can benefit from falling prices.
Due to the nature of such contracts and their flexibility, they can also be used in hedging strategies. One of them entails counterbalancing a position in a spot market with an opposite in a derivatives market. As a result, even if a trader goes long but the asset’s price falls, their losses are compensated with profits from a short CFD.
Crypto CFD Cons and Risks
- In volatile markets, a difference between bid and ask price will be higher, which will lead to less profit because brokers require higher fees.
- Not actually owning a cryptocurrency can also be seen as a minus. Holding strategy won’t work here, as CFDs are only suitable for trading.
- Not all pairs and coins are supported by brokers.
Leverage Risk
Traders often choose CFD because it offers leverage and is trading with it more often than without. Let’s say in our example, Alice did not open a $25,000 position but borrowed funds from Bob to open a $100,000 one. If the CFD played out in her favor, instead of $3,750, her profits would be $15,000 minus Bob’s fees.
However, the risk in this arrangement is that if Bitcoin’s price fell in the meantime, Alice would have to pay Bob the difference between the prices plus the premium. If her position was $25,000 and Bitcoin lost 15%, the settlement would come up to $3,750. With leverage, she would need to repay borrowed funds (75% of her position) as well. Simply put, her losses would also multiply by four. This is the main cause why up to three quarters of traders lose money trading CFDs.
This is not to say that you are finished if the market moves not in your favor. Before a position is forcibly or voluntarily liquidated, traders receive a margin call. Think of it as a warning and a notice to increase account balance to a predetermined level. If it’s met, the collateral is not sold and the position is not closed, so adequate inventory management, diversified positions, and extra steps like stop-loss orders can help manage the leverage risk.
Volatility Risk
There is another risk factor more characteristic of cryptocurrency markets. As mentioned above, volatility directly affects spreads and premiums. It also factors into leverage, making inventory more challenging to manage, and margin calls with liquidations harder to avoid.
Cryptocurrencies are extremely volatile because their value is decided mostly in the markets rather than for fundamental reasons. Since these digital assets are not usually backed by any real-world assets, speculation is the main driving force behind crypto price formation.
Volatility is more of a concern in short-term trading rather than in long-term strategies but CFDs are more common in the former. When waiting it out is not feasible, balancing positions works too. Traders use protective puts in options markets to cover another position in a volatile market.
How to Choose a Crypto CFD Broker
Regulation and Licensing
A major disclaimer that has to be made about CFDs is that they are rather complex and therefore, challenging to regulate. As a result, CFD trading is legal only in a few countries and in most places, traders have to rely on trustworthiness and reliability of a chosen broker.
The perfect case would be trading on a listed OTC market with all the consumer and trader protections ensured by the state. Where it is not possible, however, caution is advised. Perform due diligence on brokers you are about to engage with and start small.
Crypto CFD brokers would be overseen by government bodies that typically oversee trading and financial markets, such as the Securities and Exchange Commission in the US. However, there in particular, the SEC has banned CFDs altogether, leave alone the crypto variety. If you are in another jurisdiction, like Japan or Belarus, you can look up the relevant authority and proceed to their public resources to check a valid license for a CFD broker.
Trading Platforms and Tools
Due diligence is just one step in choosing a platform for crypto CFD trading. There are also fee structures, interfaces, terms, and tools to consider!
Due to the more complex nature of trading contracts, you would need more than the bare essentials in trading tools. Check if the platform supports automatic orders, which can be useful to set stop-loss or trailing orders.
Data can also give you an edge in the market and help avoid unnecessary complications with effective risk management. Of course, there are standalone platforms for market analysis like TradingView and Dune but brokers accrue valuable data too. If they share it with traders in the form of built-in analytical tools, they are making important steps to build reputation and trust, assisting their clients with making informed decisions.
Conclusion
Despite the title, CFDs might be a bit too complex for a beginner. Nevertheless, knowing more about them even before you trade CFDs yourself is a necessary step to broaden your horizons as a trader and eventually try it out.
So what are crypto CFDs? Now you know! Want to know more? Then read more articles from our blog. For content on the go, sign up for our updates on Twitter, Facebook and Telegram.
