AuthorAuthor: Alison HeyerdahlUpdated: Nov 30, 2022

Last Updated On Nov 30, 2022

Alison Heyerdahl

Contracts for difference (CFDs) have something of a bad reputation. They make governments and regulators nervous, and there are a lot of unregulated CFD brokers based in small island nations whose main goal is to fleece the unwary and the ignorant.

But despite the governmental disapproval and the scammers, there is still a lot of interest in CFDs. But first, what are CFDs? And why do governments disapprove of them?

CFDs are derivative trading instruments. They allow traders to profit from the rise and fall in a price of an underlying instrument without having to own it. The most frequently traded CFDs are Forex pairs (EUR/USD, USD/JPY, etc.), stocks, commodities, and yes, cryptocurrencies. Other common derivatives are options and futures, but whereas options and futures are traded on centralised exchanges, CFDs are traded with a broker, who acts as counterparty to trades.

The final piece of the CFD puzzle – and the one that makes the whole adventure fraught with risk – is leverage. CFDs are traded on margin. To make a decent profit with a relatively small amount of capital, CFD traders borrow money from their broker using their own money as collateral for the leverage debt. But while leveraged trading amplifies profits, it also amplifies losses. And a bad trade, when amplified 100-fold, will wipe out a trading account very quickly.

A Turbulent History

CFD trading has been around for a long while now. Invented in the early 90s by a couple of investment bankers working for UBS Warburg, they remained the province of hedge funds and other financial institutions for almost a decade. Retail CFD trading burst on to the scene in the early 00s, with the advent of internet-enabled desktops and its popularity surged with the introduction of smartphones with 4G internet connections. And as retail CFD trading grew in popularity, so the losses made by under-educated traders mounted.

By 2015, a study by the Financial Conduct Authority (the UK’s financial regulator) found that 82% of retail CFD traders lost money. The FCA also noted that “similar levels of poor client performance have also been observed in other European jurisdictions.” And so the crackdown began.

CFD trading is now heavily restricted in most developed nations and is outright illegal in some places, most notably the USA. In the UK, EU, and Australia, leverage is restricted, promotions and bonuses are banned, and all brokers must provide negative balance protection – so traders can never lose more than their initial deposit.

Enter the Crypto-dragon

Like CFD trading, the history of cryptocurrency is also a turbulent one, albeit a shorter and noisier one. Without going into a potted history of cryptocurrency, it is safe to say that its most famous aspect is price volatility. Which is where CFDs and cryptocurrency enter an unholy union.

Because CFD trading never involves owning an asset, a profit can be made whether the underlying asset’s price falls or rises. For example, if I think the price of WTI Crude will fall today, I can easily take a short position on a WTI Crude CFD and profit from the drop. Similarly, if I think the price will rise, I can take a long position. And with CFDs, the more volatile an asset, the more opportunity there is to make a profit.

It’s easy to see the advantages of trading cryptocurrency CFDs in this scenario. With an asset as volatile as Bitcoin, the profit potential is huge. This potential is exaggerated by leverage and then further exaggerated by the fact that Bitcoin is almost purely driven by risk sentiment. With Forex CFD trading, there are underlying economic concerns that drive price. But with Bitcoin trading, there is little more to do in terms of fundamental analysis than watch crypto social media feeds.

CFDs and the Crypto crash

The (most recent) crypto crash has wiped over two-thirds off the value of the cryptocurrency market. From a peak of almost 70,000 USD, the price of a single Bitcoin is now hovering around the 20,000 USD mark. The amount of money lost by crypto investors is staggering and has forced the closure of more than a few exchanges. While cryptocurrency as an asset is still not significant enough to damage traditional financial markets (as the 2008 derivative-led crash did), regulators have also launched criminal probes into how some of the larger players operated.

And this is where crypto CFD traders have the advantage over crypto investors. Anyone who stayed away from purchasing cryptocurrency, but instead traded crypto CFDs, will likely have made a substantial profit from the crash.

Risk or Risk?

But is this aspect of crypto CFDs enough to outweigh the risks of CFD trading in general? Like most things in life, it depends. Successful CFD traders, no matter what asset they trade, tend to be disciplined risk-takers with a deep knowledge of technical analysis. They tend to work with well-regulated crypto CFD brokers and don’t trade with high leverage.

It would be foolish for someone to jump into highly leveraged crypto CFD trading without a solid risk-management plan and enough capital to withstand the drawdowns that occur in such a volatile market. But then it’s also arguable that putting your life savings into a digital token with no underlying value is also foolish.

The underlying point here is that if you try to make a profit from cryptocurrency, whether through outright purchase or price speculation, never invest more than you can afford to lose, and be prepared for a wild ride.

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