If you prefer to trade Bitcoin without actually using the digital currency itself, but with solely fiat means (conventional currency) instead, you can do so with the help of artificial instruments (derivatives) known as Contracts for Difference (CFDs). We should note that CFDs are usually traded over-the-counter, in other words, not on government-regulated exchanges, and are currently prohibited in the United States and Belgium. Because of regulation costs, many CFD brokerages abstain from operating in the United States.
What is a CFD and what are its advantages?
A CFD represents a contract between a trader and a brokerage company, which enables the trader to take advantage of Bitcoin’s price movement without the need to own or buy the digital currency itself. With such instruments traders are able to speculate and earn from the difference between their entry price and exit price levels without the need to be aware how to acquire and store Bitcoins securely. CFDs also relieve traders from the necessity to address security matters associated with Bitcoin such as setting up and encrypting a wallet, downloading a back-up among others. You can think of a CFD as an agreement between the two parties, which simulates a situation as if the trader is holding the actual asset (Bitcoin).
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Beside what we noted above, another advantage of CFDs is their flexibility. They allow traders to open and close long (buy) and short (sell) positions in Bitcoin whenever they want – on any day, at any time within a day.
Additionally, fees associated with CFDs tend to be relatively low, especially if compared to other more sophisticated methods that allow you to participate in the market. However, CFD fees tend to be slightly higher compared to fees, which crypto exchanges such as Bitfinex, Bitstamp, Kraken, BTC-e and so on, would charge you if you were to buy or sell Bitcoin directly, by using their services.
Disadvantages of CFDs
There are also some aspects of CFD trading, which could be considered as disadvantages.
First of all, if you hold an active position overnight, there will be a cost, known as ”premium”. In the general case, an amount equal to 0.1% of your position size will be deducted on a daily basis from your account balance. As CFD trading is possible through the use of leverage (which is a form of borrowing), as long as you maintain your position, you will have to pay interest for the funding arrangement you have made. On the other hand, if you had actual Bitcoins in your digital wallet, you could keep them for as long as you wish without being charged any fees or other costs.
Beside the daily premium on active trades, the brokerage company will usually charge you with an additional fee every time you open a position. It is referred to as a ”spread” and also reflects the difference between the buy and the sell quotes, which the brokerage offers you.
Let us consider the following example. If the current spot price of Bitcoin is $14 555.60 per coin and you intend to buy Bitcoins at this price level, the brokerage company will not sell them to you at $14 555.60. The broker will give you a slightly higher quote, say $14 575.60 per coin. If you intend to sell Bitcoins, the brokerage will not buy them from you at $14 555.60, but at a slightly lower price, say $14 535.60 per coin. As you can see, a difference of $40 exists between the two quotes. It actually represents the spread, or the difference between the price at which the brokerage company will buy from you and the price at which it will sell to you. Since the brokerage buys from you at a lower price and sells to you at a higher price, it generates a profit.
Last but not least, let us not forget that brokerage companies will look to protect themselves against unexpected and sudden moves in prices of trading assets they offer their clients. In times of considerable market volatility, intense trading and, especially if high leverage is in play, a drastic price move against a trader’s expectations could place their account balance deep into negative territory. The resulting loss becomes a liability of the trader (client) and if he/she is not able to cover it, the brokerage company, in turn, will face financial losses. If a huge number of clients end up deep into negative territory and are unable to recover, the brokerage company could face bankruptcy.
In order to mitigate such a risk, brokerages will automatically close their clients’ positions before their account balance turns negative. In case clients find themselves in a situation where their account balance has fallen below the obligatory maintenance margin, this occurrence is known as a ”margin call”. In such a situation the brokerage will require of its clients to deposit additional amount of money in order to restore their account balance to or above the maintenance margin. Otherwise, clients will not be able to open any positions. This way the brokerage has a sort of insurance that clients will eventually pay their debt.
Note that a better-funded margin account and reasonable leverage make margin call a less likely occurrence. We shall take a closer look at leverage and margin requirements in the next article.