CFD vs Options:
What are the Differences?
Derivatives trading takes place across more than 50 organised exchanges around the globe, with Asia Pacific and North America being the largest markets for this category of financial instrument. Volumes in the global derivatives market hit a record high of 30.28 billion contracts in 2018, up from around 25 billion contracts in 2017. In currency derivatives alone, volumes crossed 3.5 billion contracts in 2018. In recent years, this market has witnessed accelerating growth, driven by Asia-Pacific and North America. These regions accounted for more than 77% of the contracts traded in 2018, with volumes surging by 31.7% and 57.2% respectively.
What is a Financial
A financial derivative is a contract that derives its value from an underlying asset. It is treated as a financial security, which means that traders agree to purchase or sell the asset at a predefined date at a specific price. While some financial derivatives are based on a single underlying asset, like a specific stock, others derive their value from a group of assets such as stock indices.
Derivatives trading covers a range of underlying assets, including bonds, stocks, commodities, currencies, indices, and even interest rates.
Why Trade Financial
There is no shortage of financial instruments available to trade in the CFD market. The number varies depending on the CFD provider with stocks, commodities, currencies, and indices among the tradable instruments. There are several reasons why traders have turned to derivatives:
They allow traders to speculate on the price movements of various assets without having to buy or own the asset.
Brokers typically offer derivatives with the chance to use high leverage, like 500:1. This gain high exposure and exponential potential profits with a small outlay. By using leverage, traders can make meaningful profits when the market moves in their favour. Leverage is a high risk trading strategy that requires the employment of risk management techniques such as stop-loss orders.
A small movement in the price of the underlying asset can result in a significant difference in the value of a CFD contract. As a result, trading opportunities exist even in a largely flat market and CFD traders look to take advantage by opening and closing a large amount of contract in a short-term period. This is commonly referred to as day trading.
Derivatives present trading opportunities in both rising and falling markets. On global stock exchanges traders purchase the actual stock meaning they take a long position. With derivatives, traders can take a short position if they expect the price of the underlying asset to fall.
These financial instruments are often used as hedging tools. When a trader has a particular asset in their portfolio, they mitigate risk by gaining exposure to a derivative whose value moves in the opposite direction.
Another reason to trade CFDs is the ability to gain exposure to certain instruments that cannot be otherwise bought or sold. An example of this is interest rate derivatives.
What are the Types of
The most common types of financial derivatives are CFDs, options, forwards, futures, and swaps. Understanding what each of these are will help highlight the differences between CFDs and options.
Contracts for difference (CFDs) are an agreement to exchange the difference in the value of a security or underlying asset between the time the contract opens and closes (expiration date). These enable traders to speculate on the rise or fall in the price of a financial instruments such as stocks, currencies, commodities, indices, and cryptocurrencies. With CFDs, traders enter a contract rather than taking possession of the underlying asset. CFDs allows traders to trade in both rising and falling markets.
Option contracts offer the buyer the opportunity to buy or sell an underlying asset at a predetermined price, on or before a specified date. The holder has two trade options - buy or sell. The contract is called a call option (to buy) or a put option (to sell).
Traders compare futures and options because the primary purpose of these derivatives is to enable the holder to lock-in the price of the underlying asset before the date of the actual trade. The key difference between futures and options lies in the obligation to purchase or sell the underlying asset. In futures, the holder is obligated to buy or sell the underlying asset at the specified price on the due date. However, with options, there is no such obligation. The holder has the option (hence the name) to relinquish the contract. The option prices at the nominated expiration date will determine the decision.
Of the two securities, futures are more popular and have larger liquidity than the market for options. Higher levels of liquidity translate to narrower spreads and lower transaction costs. Despite this, traders do consider options as a good financial instrument given the flexibility they offer to back out of the trade if the price movement is unfavourable.
Swaps are over the counter (OTC) contracts between two parties which means that they are not traded on any exchange. This, and the fact that they are customised, makes them popular only among highly seasoned traders. Swaps get their name from the fact that the two parties exchange (swap) cash flows from two different financial instruments. Generally, one cash flow is fixed and the other is variable. The variable cash flow is determined by a benchmark interest rate, index price or even currency exchange rate. Such contracts are mainly used by large businesses and financial institutions. Although such contracts can be used to exchange almost anything, they are most commonly used for trading the difference in interest rates. These are called interest rate swaps.
This type of financial derivative is most commonly used to hedge or offset risk. For instance, a shipping company that needs to buy oil to run its vessels can purchase oil futures. This would allow the company to lock in a future price for oil and define its expenses. The bottom-line would not impacted by any sudden fluctuations in crude oil prices.
Many large exporters or importers protect themselves from the risk of a change in the currency exchange rate or even changes in the interest rate by using futures. Companies sometimes liquidate these derivates before the due date by selling them in the underlying market.
The price of futures is determined by changes in the demand and supply of the underlying asset as well as changes in the demand and supply of the contracts themselves. The most popular futures exchange is the NYMEX (New York Mercantile Exchange).
In order to make their trading on exchanges simpler, futures have been standardised. They are mostly used for trading commodities, currencies, and stocks.
These contracts are more informal in nature and provide flexibility as they can be customised. They, too, constitute an agreement to buy or sell the underlying asset at a predetermined price on the agreed date. Such contracts are typically used for foreign exchange by large exporters and importers for hedging currency risk. Forward contracts are also used by traders for speculation, although they are not a highly popular financial instrument as they are not standardised. While the price is predetermined, they are often renegotiated and can be extended or closed before the due date.
What are the Advantages of
CFDs Vs Options?
Let’s have a look at the reasons why CFDs are preferred to options.
Easy to understand: CFDs are probably the easiest to understand in derivatives trading. This is why people tend to begin their journey in trading contracts with CFDs. Options are a little more complex due to the existence of premiums.
Similar to the underlying asset: CFD trading mimics trading in the underlying asset. For instance, trading in Amazon or Apple CFDs will be similar to trading the actual stock.
Wide variety of assets covered: CFDs can be traded for almost every financial instrument in the global marketplace. There are CFDs for forex, commodities, metals, stock, indices and cryptos. The most popular CFDs have higher liquidity. So, traders new to CFDs prefer to begin with these. For example, you may prefer to begin with CFDs for popular indices like AUS200, US100 or UK100, rather than exotic indices like NZX50 and KOSPI100.
Do not expiry: CFDs do not have any expiry date, giving traders the flexibility to keep their positions open for as long as they wish. On the other hand, options come with expiry dates after which they are worthless. In fact, as the expiry date approaches, the price of options decline.
Transparent pricing: The price of other contracts is determined by the demand and supply of the underlying asset plus the demand and supply of the contact. However, in CFD trading, prices are driven only by the price movements in the underlying asset. So, the price of your Amazon CFD will rise and fall in tandem with Amazon’s share price. On the other hand, the price of options is based on the premiums, the date of expiry, and the extent of volatility in the market, apart from the price of the underlying asset.
Leverage: CFDs are highly leveraged products. Some brokers offer leverage of as much as 500:1. This facility enables brokers to gain significant exposure to the price movement of the underlying asset with an extremely low amount of capital investment. For instance, if you wish to open a position for $5,000 and decide to use 500:1 leverage, you need only $10! However, traders must exercise caution when using leverage. If the market moves as the trader predicted, leverage can lead to high profits. However, if prices move in the opposite direction to what a trader had anticipated, leverage can magnify losses as well.
What are the Advantages of
Options Vs CFDs?
Here’s a look at why traders sometimes choose options over CFDs.
Lower risk: Since CFDs are usually traded with leverage, it increases risk along with magnifying profits. The risk associated with options, on the other hand, are limited to the price paid for the premium. In case the price of the underlying asset moves in the direction opposite to what you had anticipated, you can simply let the contract expire. Although you lose the premium, this is far lower than what you would have lost if you were trading the underlying asset or trading CFDs with extremely high leverage. Of course, with options, your profits are also limited to the difference in the premium.
Can use advanced strategies: Traders sometimes buy a call and put option at the same time to earn a profit irrespective of the direction in which the market moves. They execute the option that will earn them a profit and simply let the other one expire. On the other hand, CFDs do not offer such flexibility.
Trade Sideways: While CFDs offer trading opportunities in a rising and falling market, options offer trading opportunities even in a market that is expected to remain range-bound (or a market with low volatility). Traders use a strategy known as the short strangle. In this, they enter an option to buy the underlying asset at a specific strike price and one to sell the same asset at a different price. Traders buy such options if they expect the price of the underlying asset to remain between the two strike prices.
Both CFDs and options can be used for hedging. For instance, if you have 100 Amazon shares in your portfolio, you may buy a CFD or option that benefits you if its share price falls.
Why Do Traders New
to Derivatives Trading
Traders tend to begin their journey in derivatives trading with CFDs. This is because they are simple instruments. Options trading is far more complicated, and it can take some experience to know how to evaluate the risk and reward. Moreover, if the price of the underlying asset doesn’t move too much, the premium becomes a wasted expense. New traders are also a little apprehensive about the low transparency with options. There is lack of clarity into how the instrument value is calculated.
If you are looking to start trading CFDs, here are a few things to keep in mind.
Begin by using a demo account: The basics of trading CFDs are simple and easy to understand but it can take some practice to develop a trading strategy and learning how to use trading platforms. It’s a great idea to open a demo account with a regulated broker and try trading CFDs here before making a capital investment.
Always open stop-loss orders: The importance of stop-loss orders as part of risk management cannot be overstated. A stop-loss is an order that triggers the sale of the instrument when the price moves beyond a certain level in the opposite direction to what you predicted. For example, you expected Amazon’s share price to rise and purchased Amazon CFDs, but the share price falls. If you have a sell-stop order, it will trigger a sell order if the share price declined below the level decided by you.
Limit the amount of leverage you use: It may look exciting to gain exposure that is 500 times the capital you invested into the trade. However, this also increases risk. Begin by capping the leverage and consider increasing it gradually as you gain confidence and experience in CFD trading.
Develop a trading strategy: Live trading is not a place for experimenting or going with the flow to see how things turn out. Set up a strategy for each position that you open. At a minimum, identify the trend to determine the direction you expect the market to move and at what price you would like to set up your stop loss order.
Control your emotions: Once you have a established a trading strategy, give it time to play out. Making sudden decisions in the heat of the moment rarely work well for traders. When emotions run high, we tend to make the worst mistakes. Don’t quit at the first sign of a loss: Even the most successful traders have some rainy days. So be prepared to have some good days and some bad days.
Diversify your portfolio: Choose a variety of markets and assets to trade. To diversify effectively, you need to know how markets are related. For example, if you have exposure to oil, you may not want to trade the Canadian dollar as well, as it is a commodity currency. Both will probably move in the same direction. Similarly, if you have exposure to CHINA50, you may not want to trade the Australian dollar. Since China is Australia’s largest trading partner, the AUD may decline when CHINA50 does.
Finally, choose a reliable and regulated CFD broker. This will ensure a seamless trading experience.