At the time of writing, the total market capitalization of digital currencies is a staggering $1.62 trillion, attesting to the ever-increasing growth of this unique asset class. Despite being complex to understand and essentially opaque, mainstream awareness and acceptance are spreading.
Aside from the well-known exchanges such as Coinbase, Gemini, and Binance, other traditional CFD brokers have begun offering cryptocurrencies. A high amount of speculative interest exists within this financial instrument.
For investors to get in on the action, they now have the luxury of online trading aside from owning the coins outright through an exchange.
Fortunately, most of the steps involved in trading cryptocurrency CFDs are similar to those available in speculating with other more established markets such as equities and currencies.
This article will cover how CFDs within cryptocurrencies function and some of the advantages and disadvantages to note.
What are cryptocurrency CFDs?
CFD, an acronym for contract for difference, is an agreement a trader enters with a broker to trade a market without any ownership of the underlying instrument. At the end of the contract, the broker promises to settle the difference between the opening and closing price of the position (hence ‘contract for difference).
If the difference is positive, the broker pays this to the trader; if the difference is negative, it is taken from the trader’s account. Virtually all online-traded instruments, ranging from stocks to metals, are CFDs as their value is derived from an underlying real-life product.
What is involved in a cryptocurrency CFD?
Most crypto CFD trades consist of the following three things; a spread or commission, a position size, and leverage.
The spread refers to the variance between the bid and ask prices, which is essentially the broker or exchange’s mark-up for sourcing liquidity for a particular market.
The position size is the number of lots or contracts the trader wishes to allocate for every trade in relation to their equity and maximum leverage available.
Traders have no limitations in how long they can hold their positions, provided they can maintain the margin requirements without having a margin call.
Lastly, leverage or margin is a mechanism common in all CFDs allowing someone to open a much larger position with a relatively tinier balance. In a nutshell, it affords traders more buying or selling power.
Nowadays, leverage in crypto starts from 1:2 and goes up to 1:200, depending on the broker or exchange. For a better illustration of leverage, let’s consider an example with 1:200. If someone deposited $10 000 with this ratio, they could open a position worth up to $200 000 on Bitcoin.
A mere 2% return would see a $4 000 increase on the trader’s account. Conversely, a decline of the same percentage would result in a $4 000 loss on their equity. It is these contrasts making leverage a ‘double-edged sword.’ Hence, only the most skilled and experienced traders with stringent money management should use it.
Pros and cons of trading cryptocurrency CFDs
Let’s look at the good and bad of cryptocurrency CFDs.
Pros
CFDs for any market, in general, provide attractive benefits. For starters, traders have the same exposure to the underlying market without any ownership of the actual coins, which is typically more expensive because of exchange fees.
One does not need to own a digital wallet. Secondly, using leverage is another massive advantage. It allows even those with smaller capital to potentially realize bigger gains in a shorter period than buying or even mining the crypto in question.
Another benefit of CFDs is the ability to go long and short with ease. When owning the coin outright, investors only have the luxury of buying. They technically only sell to either realize a gain or loss.
With a CFD, traders can sell when they believe the value of a certain coin will decrease aside from buying it in the belief of a potential future increase.
Cons
As expected, the biggest disadvantage with CFDs is the excessive losses one can experience with the reckless use of leverage. In most cases, these unfortunate events occur because CFDs are geared towards speculating instead of investing.
Coupled with the highly volatile nature of cryptocurrencies and leverage, we can have a recipe for disaster.
Essentially, a trader needs to time the market, which is not always possible to do consistently. The amount of time someone can realize a loss is a lot shorter primarily because of leverage.
With traditional investing, investors can hold a particular coin even when it’s technically losing value, provided they don’t sell.
So, although having no ownership is advantageous, it does have this downside as well. Lastly, most CFDs have overnight fees (aside from the spreads or commissions) that could accumulate to undesirable amounts over time if the trader held their orders for extended periods.
Factors to consider before participating in trading cryptocurrency CFDs
Before trading cryptocurrencies through CFDs, here are some things to consider:
- Finding a reputable broker or exchange: Cryptocurrencies are probably the most unregulated financial market due to their inherent decentralized nature. It becomes more imperative than ever for potential traders to use the most reputable brokerages or exchanges with proven safeguarding practices in this regard.
- Getting familiar with the demo account: Even for experienced traders, anyone needs to spend sufficient time on a demo account to familiarise themselves with the provider’s conditions and execution overall.
- Having a well-defined trading plan and strategy: This phase involves a thorough understanding of the chosen instruments through an iterative research process and rigorous testing of a strategy.
It’s a combination of mastering technical and fundamental analysis. At this stage, traders will have defined their risk parameters and goals to ensure they stand the best chance of success.
Final word
While there are other methods of gaining exposure to cryptocurrencies, such as the actual purchase of coins, index/investment funds, or mining, CFDs have become more prominent in this regard.
As cryptocurrencies can often move in significant price differences, they have become a favorite amongst traders. Like any other financial instrument, succeeding in this market is less about focusing on the profit potential and more about managing the inevitable risks involved.