The next frontier in Bitcoin trading is certainly the derivative space. Traders are actively looking for exchanges that allow them to trade futures, options and other derivatives. A host of FX brokers and exchanges have opened up recently and are offering derivative products. By far the most popular offering is a Contract For Difference (CFD).
According to Investopedia a CFD is:
This is generally an easier method of settlement because losses and gains are paid in cash. CFDs provide investors with the all the benefits and risks of owning a security without actually owning it.
What makes CFDs so popular is the extreme leverage that different brokers will offer clients. As of right now there are CFD brokers offering up to 20x leverage on Bitcoin vs. the US dollar. Unfortunately this enhanced leverage comes a cost, and most likely a very great one that many investors just don’t realize.
To trade a CFD a trader will need to post margin to fund his position. The lower the margin the higher the leverage (e.g. 10% margin requirement leads to 10x leverage). There are two numbers traders need to pay attention to, the initial margin and the maintenance margin. The Initial Margin (IM) is the amount you must deposit with your broker or exchange to initiate a position long or short. The Maintenance Margin (MM) is the bare minimum amount of margin you must have against your portfolio. If you breach this level, your broker or the exchange will margin call you and close all of your open positions.
The margin process is pretty straight forward. So now let’s look at how CFD brokers are making money. Your broker will normally charge you a daily funding charge. Essentially this is the interest rate you pay to borrow money from the broker and gain access to higher leverage. These usually range from 0.10% to 1.00% per day on the total notional of you position. For example, you have a long Bitcoin vs. USD position with a Bitcoin notional of 100 BTC. You deposit 10 BTC for initial margin and if your margin balance drops below 5 BTC you will be margin called and the broker will close you positions. The daily funding charge is 0.50% per day which equals 0.50 BTC per day of fees (0.50% * 100 BTC Notional Position). If the BTCUSD rate does not move, you will be margin called in 25 days just from the funding charges alone; you have a 5 BTC cushion (10 BTC IM – 5 BTC MM) therefore 5 BTC / 0.50% Daily = 25 days. Talk about a usurious interest rate, you are paying over 500% annualized in interest just to trade this derivative ((1 + 0.005)^365 – 1 = 502%).
Make sure you read the fine print; not all derivatives exchanges and brokers are created equal. You might believe that Bitcoin is going to $10,000 per coin or to $0, but if you are trading CFDs and the market isn’t moving you are going to be up the creek without a paddle.