El cryptocurrency trading as Bitcoin It has become an activity that generates enormous financial and economic movements in the world, and one of the tools that seeks to help take advantage of this are the CFDs or Contracts for Difference.
And it is not for less, with a value that has exceeded an average of 200 billion dollars, Bitcoin is a cryptocurrency with an imposing and important economic level throughout the world.
This is a fact that has not gone unnoticed by investors and financial companies looking to transform Bitcoin into a market of great value. A market that attracts even more the attention of investors globally and that makes it grow in value.
In that sense, CFDs (Contracts for Difference) stand as a perfect tool to boost these events. In Bit2Me Academy we wanted to dedicate a space to explain what CFDs are and the impact they are having on the world of Bitcoin and cryptocurrencies in general.
What is a CFD and its origin?
A CFD or Contract for Difference (from English, Contracts for Difference), are financial instruments whose price is based on the difference between the entry price and the exit price of an underlying asset. Simply put, a CFD reflects the value status of an asset both at the beginning and end of a day.
Thanks to these features, traders have the opportunity to trade different types of assets without owning them, such as indices, stocks, futures, etc. For example, when buying a CFD on a share, you are not the owner of the share, you have a contract with the broker.
This means that CFDs are derivative instruments of the type OTC (Over The Counter) or other unregulated secondary markets. That is to say, They are not listed on an organized market but on private markets and their negotiation is done between trusted parties. For this reason, many regulations in different countries mark CFDs as a highly risky investment option and even impose strong restrictions on its use.
The origin of CFDs takes us to England in the 1950s, when they were created in order to facilitate access to the trading of operations with a lot of leverage, especially for hedge funds. In Spain, CFDs began to be traded in 2007. Since then, the CNMV y ESMA (European Securities and Markets Authority) they have issued several warnings about these instruments.
How does a CFD work?
As its name implies, CFDs consist of a contract that allows you to buy or sell an asset taking into account the difference in price of said asset. At no time is the asset needed, and you can "buy" or "sell" something that you do not have. In this way, the gain or loss of said opposite is given by the difference between the entry price in the position and the closing price of the position.
For example, if we create a CFD of € 10.000 with an entry position price in Bitcoin of € 8000 and an exit position price of € 8500, we will be facing a contract with a positive profit of 6,25%. That is, this contract will return us a total of € 625 profit, for a total of € 10.625 in our final position withdrawal.
However, of those € 10.000 in position, only a small part is really our investment, because the capital has been increased thanks to a leverage granted by the broker's platform. Hence, the only thing we earn is our initial investment, a percentage of the profits obtained by the CFD, less the commissions and interests that the platform charges us. And in case of losses, we can lose all our money.
Leverage, the main characteristics of CFDs
So we can say that; CFDs are “leveraged” products. In addition to offering exposure to the markets, requiring the investor to contribute only a small margin (deposit) of the total value of the operation. In this way they allow investors to take advantage of rising prices (assuming “long positions”) or decreases (assuming “short positions”) of the underlying assets.
If you hear the phrase "go short" it means that it refers to a sell order. And on the contrary if you hear "go long", where it refers to a purchase order.
When the contract is closed, the investor will charge or pay the difference between the closing and opening values of the CFD of the underlying assets. If the difference is positive, the CFD provider will pay you. If the difference is negative, you will have to pay the CFD provider. This situation is what often leads investors who do not know how these tools are managed to have large losses.
On the other hand, CFDs may seem similar to more conventional investments like stocks, but the truth is they are very different. This is because in the case of CFDs, the investor never actually acquires or owns the asset underlying the CFD, he only has a contract that allows him access to a simile of said asset in a private market.
Pros and Cons of CFDs
Of course, CFDs are not a perfect tool and like everything else, it offers pros and cons when using it. So we have the following:
Pros of CFDs
- They are a tool that allows direct access to the market (Direct Market Access or DMA, for its acronym in English). This allows some Brokers can allow you to invest in CFDs directly in the market, without going through intermediaries.
- The operations carried out with CFDs allow generating profits in bull and bear markets, something that is not possible with other financial instruments.
- It allows operations with leverage.
- Unlike regulated markets, CFDs allow you to trade 24 hours a day, 5 days a week.
- You can adapt the amount you invest in CFDs (the volume of the contract) to the size of the account or the maximum risk you want to take as an investor.
- In a supposed case of dividend distribution, the long-term investor in Contracts for Difference maintains all economic rights. If the investor operates short, he must pay the corresponding amount as dividends. The difference with futures in this regard is that they do not have economic rights.
Cons of CFDs
- They are quite a complex product to understand. In Spain, the CNMV considers that they are not suitable for retail investors due to its complexity and high risk. In fact, 70-90% of retail investors lose all their money when trading CFDs. There are many platforms that allow you to invest in Bitcoin, but you actually buy a CFD. With Bit2Me you buy real Bitcoins.
- Trading CFDs requires constant monitoring and surveillance of your investment. Remember they are complex instruments and the markets in those that are usually applied are usually very volatile.
- It is often said that these contracts do not have an expiration date, unlike futures. This is partly true since keeping the position open generally generates the payment of interest for said option.
- Long operations carry a financing cost. This cost corresponds to the part of the total investment that is not covered by the margin of guarantees.
- Not all CFDs have the same liquidity, so in some cases we can find that there is no counterpart for the operation.
- Many brokers offering CFDs are outright scams that simply seek to capture their victims with the promise of easy money and profits that do not correspond to reality.