Although the many different terms for investment and trading instruments may seem confusing at first glance, anyone who is serious about using CFDs must take the time to learn about and understand what each one actually means.
When it comes to CFDs, many people often ask if and how they are different from futures and options. The answer is that all three are “derivative” financial products, meaning that trading in them does not actually involve owning the underlying asset at any point.
Because the value of a derivative comes directly from the value of another asset, such as a share in a listed company, a commodity of some kind or even a market index, a position emerges during trading in regard to how the change in value of the underlying asset will take place over a period of time.
CFDs and futures are both derivative financial products. One major difference between them is that a CFD trader never owns the asset, while a futures contract sees a trader agree to buy or sell it at a set price at a particular time, despite any prices changes that happen in the intervening period.
Professional investors often use futures contracts for indices and interest rate trading, principally because they have a history and are therefore known as a mature product. They also trade on exchanges.
However, CFDs have the advantage of smaller contract sizes and pricing that is more transparent. These elements make them more appealing to small traders. Many providers often write CFDs over futures due to the easy availability of futures prices data, resulting in them being able to hedge their own positions.
An option is another financial derivative that also has some things in common with CFDs, However, some aspects make the two quite different in terms of how they work. In essence, an option gives a trader the chance to buy the underlying asset at an agreed price at a certain point in time, but unlike a future, there is no obligation to do so.
One of the reasons that options are popular is because they are tried-and-true, mature products that are exchange-traded in the same way as futures. Options can mitigate risk by hedging or speculate by taking on risk.
Again, one of the main advantages that CFDs have over options is that pricing is far simpler. Option pricing is a complex process that has to take price decay into account when it nears the expiry date, while CFDs prices mirror the underlying instrument as it rises or falls. The fixed expiry period can also be a disadvantage for options trading, while the flexibility of a CFD allows for a much more flexible approach.
With both futures and options, there are specific time periods involved that set an expiry date on the trade. This obligation or opportunity to buy, depending on which product is trading, means that there is more exposure involved than with trading in CFDs.
Time wastage is the period when the writers of the trades make their money out of the buyers, and this can lead to large drops, even if the asset prices are increasing. The difference between the option/future price and the actual asset price at this point is where some unwary traders can run into difficulty. The flexibility of CFDs means that this is never a problem.
Accounts and interest
Of course, a CFD is a leveraged derivative, but it also has another major advantage over futures and options. It is much easier to open an account to trade CFDs than it is for the other products, even though both leverage the trader’s money. This is because there is less red tape surrounding CFDs and far less seed capital is necessary to begin trading.
Interest charged by brokers is also another key issue in the difference between CFDs and other products. Most derivatives see the interest charges priced into the underlying asset, while CFDs receive charges on a daily basis. This can be an important point, as CFD traders, particularly those using technical analysis, will often only hold them for a short time. However, the inherent flexibility of a CFD means that traders can hold them for longer, while both futures and options are set in stone.
The bottom line is that comparing CFDs to futures and options is something of a mistake due to the former’s lack of a set expiry date. CFDs are very different financial instruments in a fundamental way, even if they may share some common derivative attributes.
Another basic difference is the simplicity of CFDs. With other derivatives, there are many different strategies that traders can use that often are not easy to understand and complex when put into practice. However, with CFDs, the basic decisions revolve around whether to go long, short or flat, so taking a trading position can be far more straightforward.
Different investors want different things, and this is why there is such a mixture of financial instruments and products to choose from. CFDs require active involvement from a trader, and for many, this is a big part of their appeal. Those looking for long-term positions or “buy and forget” trading will see disadvantages to CFDs because they can be expensive to maintain a position. However, short-term traders, even those who are reasonably risk-averse, can find much to like in the flexibility that CFDs offer.