Take a closer look at the risks and potential rewards of trading cryptocurrency CFDs.
The recent surge in the popularity and public awareness of cryptocurrencies has seen an increasing number of trading platforms offering their customers access to global crypto markets. In particular, a wide range of providers has started offering “contracts for difference” (CFDs) on a number of popular cryptocurrencies.
So, what exactly are cryptocurrency CFDs, how do they work and what are the risks involved in trading them? Keep reading to find out.
What are cryptocurrency CFDs?
Cryptocurrencies are digital currencies designed to act as a medium of exchange. They use cryptography to track purchases and transfers, relying on the Internet to guarantee their value and confirm transactions. The best-known cryptocurrency is of course bitcoin (BTC), but other popular options include Litecoin (LTC), Ether (ETH), Ripple (XRP) and Bitcoin Cash (BCH).
A CFD is an agreement based on an underlying asset, traditionally a share, index, commodity or currency pair. When you open a CFD trade, you speculate on whether you expect the value of that underlying asset to increase or decrease. You never actually own the asset, but instead predict rises or falls in its value.
For every point the price moves in your nominated direction, you’ll be paid multiples of the number of units you have bought or sold. However, if the price moves in the opposite direction to the one you predicted, you’ll take a loss.
A cryptocurrency CFD allows you to predict the future change in value of specific cryptocurrencies. Many CFDs allow you to open contracts on the performance of a crypto relative to a fiat currency, usually US dollars (USD), but some providers also offer crypto/crypto CFDs, for example, BTC/ETH.
How do cryptocurrency CFDs work?
Cryptocurrency CFDs allow you to speculate on the value of a cryptocurrency pair, such as the following:
If you think the value of a cryptocurrency will rise, you can “go long”; if you expect it to decrease, you can “go short”. This offers the potential for you to make a profit in both rising and falling markets.
One of the key concepts you need to understand before trading cryptocurrency CFDs is leverage, which is both a key benefit and disadvantage of this type of derivative. To open a CFD trade, you only need to deposit a small percentage of the trade’s total value. This could be 20%, 5% or even less of the total transaction and is known as the margin requirement. So if you’re opening a trade worth $10,000, for example, you may only need to pay a deposit of $500. However, you can still receive 100% of gains if the price moves the way you predict.
On one hand, trading on margin allows you to magnify your returns, providing the potential for a much bigger return from a relatively minimal initial amount. On the other hand, it also means your losses are magnified as they are calculated based on the full value of the position. This means you could end up losing much more than your initial deposit. This is a key risk you must be aware of before getting into crypto CFDs.
If you’re considering trading cryptocurrency CFDs, make sure you understand all the important terms and technical jargon first. Key terms you need to know include the following:
Ask price. This is the price at which you can buy a CFD.
Bid price. This is the price at which you can sell a CFD.
Leverage. Leverage is a trading tool that allows you to buy and sell CFDs with more capital than you actually have. As CFDs are leveraged, you only need to deposit a certain percentage of the full value of the trade to open a position. For example, if you open a position on a cryptocurrency with $1,000 and select leverage of 5:1, your trade is worth five times your initial outlay – so $5,000 instead of the $1,000 you committed upfront. Using leverage allows you to enjoy greater profits if the price moves in your favour, but it also means you’ll suffer greater losses if the price moves against you.
Margin. This is the amount of money you’ll be required to deposit to open a CFD position. For example, if the margin requirement is 20% and you’re placing a trade worth $1,000, you’d need to deposit $200.
Stop loss. A stop loss order is a trading tool that allows you to set a predetermined price level at which your CFD position will be closed. This allows you to minimise your losses if the market moves against you.
Take profit. A take profit order functions in much the same way as a stop loss order, but with the key difference that you set the price level at which your position will be closed so that you can secure any profits before the market moves against you.
Trading cryptocurrency CFDs vs trading cryptocurrency on an exchange
When most people buy and sell cryptocurrencies, they do so through a cryptocurrency exchange. This involves using fiat or digital currency to buy the crypto coins of your choice, then holding those coins for a period of time in the hope that they’ll increase in price and you’ll be able to sell them for a profit at a later date. It’s a simple and straightforward way to potentially benefit from cryptocurrency price rises, and trades can be placed on centralised or decentralised exchange platforms.
CFDs offer a different and more complicated way to trade cryptocurrency. Although they’re a relatively new addition to the world of crypto, CFDs have been around for a long time in other financial markets such as shares, forex and commodities. The key difference that sets them apart from buying coins or tokens on an exchange is that when you trade CFDs, you never actually own any cryptocurrency – rather, you forecast whether the value of a particular digital currency will go up or down. If the price of that cryptocurrency moves in the direction you predict, you will make a profit, but if the price moves against you, you will have a loss.
Though CFDs are more involved and intimidating than the straight-up buying and selling of cryptos, they do allow you to avoid the security risks associated with trading on an exchange. They also offer the chance to profit in rising and falling markets and the potential for higher rewards – but with these benefits comes an increased level of risk.
Benefits of cryptocurrency CFDs
The following are some of the potential benefits to trading cryptocurrency CFDs:
- Trading on margin could allow you to magnify gains
- You can trade cryptocurrencies without actually having to own any cryptos
- No need to open a crypto storage wallet or deal with crypto exchanges
- Can benefit in rising and falling markets
- Easy to get started using fiat currency
- CFD trading platforms tend to offer much better customer support than traditional crypto exchanges
- Access to an increasing range of popular cryptos
- Stop-loss and take-profit trading tools available to help reduce risks
However, you should also make sure you’re fully aware of all the following risks associated with cryptocurrency CFDs:
- Trading on margin means losses are also magnified
- You could lose much more than the amount you deposit
- Not suitable for holding onto long-term
- Cryptocurrencies are highly volatile and speculative
- CFDs are also speculative
Cryptocurrency purchase or cryptocurrency CFDs – which is better?
Whether you want to buy and hold cryptocurrency, trade cryptocurrency CFDs or even pursue both options depends on your personal preferences and trading habits.
Why buying and holding cryptocurrency might be better for you
Buying cryptocurrency, holding it for a certain amount of time and then selling it for a profit (hopefully) is generally regarded as a more popular option for people looking towards the long-term.
Unless the crypto you purchase hits a value of $0, there’s minimal risk of losing all your money with this approach. However, you will need to contend with higher spreads that are offered on CFDs, not to mention the hassle and risks associated with buying crypto on an exchange (such as security threats and the need to open a secure wallet to store your coins).
Why cryptocurrency CFDs might be better for you
On the flip side, cryptocurrency CFDs are commonly seen as being worth considering for advanced traders who are keen to adopt short-term positions. Their lower spreads make it possible to capitalise on smaller price movements, while there’s also the potential to profit regardless of whether the market is going up or down. Of course, there’s also the fact that margin trading means any gains are magnified.
However, margin trading makes CFDs very risky and, when they’re combined with highly volatile cryptocurrencies, there’s a very real danger of suffering substantial losses. In November 2017, the UK’s Financial Conduct Authority even went as far as to issue a warning about what it described as “extremely high-risk, speculative” cryptocurrency CFDs, which should be enough to make any trader tread with caution.
The most important thing to remember is that, in the right circumstances, both options can potentially provide positive results, just like you could also suffer sizable losses if things go wrong. Whichever option you choose is entirely up to you and your preferred trading style.
At the time of writing, the author holds XLM and IOTA.