(Source: Jason Briscoe via Unsplash)
Most people start trading cryptocurrencies through crypto exchanges, which is the most obvious option.
However, there’s another option that allows traders to speculate on price movements without actually owning or holding the underlying cryptocurrency. We can achieve this type of trading using contracts for difference (CFDs), an instrument that’s very popular in the world of stock trading.
But how does a CFD work, and why would you use it? This article explores crypto CFDs and compares them against exchange-based trading.
What is a Contract For Difference (CFD)?
First, let’s dive a bit deeper into the ‘What’ of CFDs. Trading contracts for difference is a way of speculating on financial markets that don’t require the buying and selling of any underlying assets. When you trade a CFD, you agree to exchange the difference in the price of an asset from the point at which the contract is opened to when it is closed. You can create such contracts via CFD brokers.
The main benefit of this approach is that you can speculate on price movements in either direction. For instance, you expect the price of Bitcoin to enter a bear market for the upcoming months. It’s a great entry point for opening a short contract with a CFD broker. More on this strategy later.
So, what are the pros and cons of cryptocurrency CFD trading?
Cryptocurrency CFD Trading vs Exchange-based Trading
Here’s a list of arguments that favor CFD trading or exchange-based crypto trading.
1. CFD: Cheaper option for leveraged trading
CFDs offer a cheaper alternative for leveraged trading. Many crypto traders avoid opening leveraged positions due to the high fees exchanges charge. It’s certainly not a good idea to open a long-term leveraged position via a crypto exchange.
Exchanges like Kraken.com charge up to 0.02% to open a position and up to 0.02% (per 4 hours) in rollover fees to keep it open. This means you’ll pay six times per day a fee of 0.02% on your total position. In other words, fees accumulate rapidly and discourage traders from opening long-term leveraged positions.
2. Exchange: A wider variety of crypto pairs
While CFD trading might be cheaper for opening leveraged or short positions, you are often limited in the variety of cryptocurrencies offered. Some crypto exchanges offer more than 300 cryptocurrency pairs for you to choose from. For instance, popular crypto exchange Binance offers its users 1132 crypto pairs.
(Screenshot: tradingview.com Bitcoin trading)
3. CFD: Great for hedging risks
Traders want to find new ways to protect their trades. Hedging is one such example of protecting a trade against volatility or external circumstances that can affect a cryptocurrency’s price.
Most often, traders use hedging to offset the risk of their position by opening a trade in the other direction when the market is unclear or they are concerned about the stability of the market.
For instance, you want to hold Bitcoin long-term, but you expect the Bitcoin market to turn into a short-term bear market. To offset the risk of this bear market, you can open a short position via CFDs. In other words, if the market falls, you can cover some of the loss to your initial position with the gain from this short position.
The most common types of risk include but are not limited to:
- Crypto hacks
- Smart contract failure
- High market volatility
- Regulatory risks
- Entering a bear or bull market
4. Exchange: You own the cryptocurrency
When using an exchange to trade cryptocurrency, you can choose between an exchange that uses hot wallets or one that allows you to generate new wallets to which you own the private and public keys.
When you want to truly own your crypto, you should pick an exchange that provides you with the private and public keys of your crypto wallet.
When trading CFDs, you don’t own any crypto. A CFD is a derivative instrument that is merely used for speculation. If you want to truly own Bitcoin or any other cryptocurrency, your best choice is to pick an exchange that gives you access to your crypto wallet. You can also buy cryptocurrencies and send them to a non-custodial wallet you own.
5. CFD: Better risk management tools
By now, most exchanges and CFD brokers offer risk management instruments or tools such as setting a Take-profit or a Stop-loss order.
(Source: Stop-limit order Binance.com)
However, CFD brokers often offer users other protection mechanisms. For instance, they protect users against negative balances, which means you can’t lose more money than you’ve deposited. It’s a promise many crypto exchanges can’t always guarantee. When trading, you don’t want to worry about the possibility of losing more money than you initially planned as the worst-case scenario.
Besides that, they also offer a guaranteed stop-loss to ensure your position is closed at the pre-selected price. It’s an important risk management tool some exchanges can’t offer due to slippage during high volatility.
What’s best: Crypto exchanges or CFD brokers?
We can’t conclude on a definitive winner just looking at the above arguments. Both approaches have their own set of advantages. Yet, we can conclude the following.
If you are a long-term crypto investor, you can use CFDs to hedge your position against any type of risk. Moreover, it’s much cheaper to use a CFD broker than to open a leveraged trade than to use a crypto exchange to hedge your risk.
On the other hand, if you are a trader who likes to frequently open short positions, CFD trading might be a cheaper option for you.
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