If you are an investor, chances are that you have held a few stocks via your brokerage firm.
Long term investors do not merely invest in a financial asset, but also actively manage their holdings. In doing so, one can reap the benefits of the ups and downs in the market.
But actively managing a portfolio requires one to be knowledgeable about the markets they are trading in. And it is not just the market information, but also knowledge of the various tools available.
In the financial world, investors have a choice of using different ways to trade the same asset.
While the traditional way is to buy and hold, you can also use derivative contracts to trade the same asset.
This can be done for speculative purposes or for hedging out the risks on the underlying asset.
This article discusses the differences between CFDs or contracts for differences and options contracts. Both are financial derivative instruments tracking the same underlying price.
But the way these two derivative contracts track the underlying price is different. Read this article which gives you a complete overview of the difference between CFD vs. options.
When it comes to investing, the biggest obstacle to making money is a risk.
Prices seldom move in a straight line and trends do not hold for long. While it may take months or years for a trend to evolve, it can change in a matter of days.
When this happens, investors have a choice to either hedge this downturn, or to liquidate their position. While liquidation may seem a simpler way out, it can put you out of the markets.
What if the markets turn back higher right after you sold off your holdings?
Or what if you thought that the markets would reverse the correction, but end up falling even more?
To answer these questions, the financial markets use derivatives that are hedging tools. Using these hedging tools, an investor can expand on the choices they have.
Thus, instead of merely liquidating their positions, investors can use synthetic or derivative financial instruments to hedge out the risks.
Among the many financial instruments available, CFDs and options are the two most commonly used hedging instruments. Other popular derivatives include futures and forward contracts as well as swaps.
To understand the differences between trading CFDs and options, you need to know how these two derivative contracts work.
In the next two sections, we will cover the basics of CFDs and options.
CFDs are contracts for differences. These contracts are used for settling the difference in the prices of the underlying contracts.
Because of its derivative nature, CFD contracts track the underlying prices of the asset that it is tracking.
CFD contracts have many benefits. Besides hedging, CFD contracts allow traders to trade in financial instruments that are not generally available.
For example, the US S&P500 stock index is just an index, tracking the performance of the top 500 blue-chip companies. If you want to own a piece of the S&P500 index, you cannot directly invest or speculate on the index.
You will have to make use of derivatives such as CFDs (and ETFs) to gain exposure to the underlying index.
Hence, a CFD contract for the S&P500 merely replicates the prices in the underlying contract.
CFD contracts are synthetic in nature. When a trader buys a CFD contract they speculate on the prices alone. CFDs do not allow traders any specific benefits of the underlying asset.
For example, if you purchased a CFD contract for APPL, then any dividends or voting rights available to the shareholder is not applicable. This may make you wonder about the incentive of trading a CFD contract.
There are many reasons behind this, the biggest being the ability to hedge the underlying position. This will allow the investor to go long or short on the CFD contract without having to liquidate their holdings in the underlying asset.
CFDs are more widely available as forex brokers also offer these instruments. Whereas, to trade the actual stock, you may need to open an account with your stock broker or via your bank.
Options contracts may look similar to CFD contracts. After all, they are also speculative instruments used primarily for hedging.
But depending on what financial asset an option tracks, the purpose of using options can differ. The biggest benefit of trading with options is the fact that it has limited risk. Combine this with the optionality feature of the options and you have a very efficient derivative product.
A trader can purchase PUT or CALL options if they believe that price will rise or fall. These PUT and CALL options come with a ratio of 100 shares. Meaning that one contract of PUT or CALL is equal to 100 shares of the underlying asset.
If the option expires in the money, the investor can exercise their option and profit from it. On the other hand, when the option expires out-of-the-money, the investor can walk away from the deal.
This optionality makes options contracts speculative in nature. Investors use options largely as a way to hedge their risks, which is to ensure the holdings in their portfolio.
Options contracts can track a multitude of underlying instruments. The main types of options contracts include forex options, equity options, commodity options, to name a few.
Similar to CFDs options contracts also do not entitle the holder to any privileges that one gets when investing in the underlying asset.
But investors do not bother about this because options are secondary lines of financial instruments. Their sole purpose is to allow for hedging which is otherwise impossible.
An investor cannot short sell a stock, but they can easily go short via purchasing PUT options.
So far, we have seen how contracts for differences and options contracts work. In this section, we outline the five big differences between trading CFDs vs options.
This will help investors understand in more detail on how these two hedging instruments differ, despite serving the same purpose.
The question of whether you should choose CFD or options is up to you. But the below differences between CFD and options trading gives you an idea on when you can choose one of these instruments.
Optionality is the key difference between an options contract and a CFD. When you purchase a CFD, you have to hold that position.
It is almost similar to how you would invest in a stock. You have your trading capital, part of which is locked up as margin. This margin amount is available to you only when you liquidate the position.
On the other hand, options require just an upfront fee. This is the premium that you pay as a buyer. Once you pay the premium, there are no other obligations. If and only if the option contract is favourable to you, then can you bring in the optionality.
This optionality gives you, the buyer of the option the choice to exercise the contract. In turn, it obliges the seller to settle the option.
For example, you purchased 10 CALL option contracts in APPL at a strike price of $150. The options contract has a three month expiry time. The initial premium you paid was $2000. AAPL’s stock was trading at $105.
Upon expiry, your option expired in the money. This makes it favourable for you to exercise the contract.
Hence, upon the option expiry, APPL stock was trading at $200. When you exercise the option, these 1000 shares (10 x 100 shares) are delivered to you.
This is cheaper because you only paid $2000.
If you actually purchased 1000 shares in APPL, it would cost you $105 x 1000 = $105,000. Thus, using just $2000, you were able to buy APPL shares cheaply. You could then sell the shares you received for a profit.
Unlike CFD contracts, all option contracts come with an expiry time.
This makes it unique and also demands a different way to analyze the options contracts. With a CFD contract, you can buy and hold the contract for good. You can then choose to liquidate the contract at your own wish.
This can be just one day after, a week or even a few months.
With options, on the other hand, there are strict expiry times. The most common options contracts come with a three-month expiry time. With OTC options contracts, it can be tailored to your requirements.
The question of whether the option expired in or out of the money depends on the expiry time.
For example, you purchased one PUT option contract in ADBE stock with a 3-month expiry time and strike price of $450. ADBE stock is currently trading at $550 and you expect the price to fall below $450 in three months.
The stock price fell below $450 in the second month. But the price recovered into a sharp rally and rose to $600 by the end of the option contract. Despite the stock price falling below $450 at one point, it still closed above the strike price.
This would make the options worthless.
Hence, timing is an important aspect when it comes to using options as a way to hedge. This is not the case with CFD, because you can just open a synthetic long or short position for as long as you wish.
Because options contracts have the expiry or the time-decay factor, there are different options strategies that one could use.
The most common option strategies are:
- Straddle: The options straddle allows the investor to buy a PUT and CALL option of the underlying security. A straddle has the same strike price with the same expiry date. With this method, one of the two options will expire in the money. A straddle is used when you are unsure on the direction of the contract.
- Strangle: A strangle strategy is similar to a straddle. The difference is that the strike price differs between the CALL and the PUT. A strangle is more appropriate to use when the market is expected to breakout from a range. This will enable traders to speculate in the breakout in any direction.
Besides the above two simple options strategies, other strategies include:
- Covered calls
- Bull/Bear spreads
- Risk reversal and many more
Comparing the above with CFD trading, an investor can only go long or short. They can of course open both a long and short position, but because the risk is unlimited it can get risky. Furthermore, not many brokers allow both long and short positions on a CFD.
The potential to lose money is higher in a CFD. It is basically determined by the stop and limit trades that you will use to limit your risks and take profit levels.
When it comes to the choice of brokers, there are more brokers who offer CFDs than options. This is because deriving the CFD prices is easy. A CFD contract simply mirrors the price movements in the underlying asset.
Whereas an options contract is different. Because option contracts are a lot more complicated, not many brokers allow for this.
There are only a select few brokers that allow you to trade options. Because of this factor, commissions on options contracts are a lot higher than trading CFDs.
But one should also look at the underlying commissions. In a CFD contract, you may pay a certain fixed cost for opening and closing the trade.
But when you keep the CFD position open over a few days, you will also be charged extra swap fees.
These are rollover or swap fees or financing fees. In many cases, you will be deducted these fees regardless of whether you are long or short on CFDs.
With options contracts, there is just one straight commission fee and that is nothing more beyond that.
Hence, in some ways an option contract may seem expensive to trade. But one should not look at just the headline commissions that you pay. You should also be calculating the total cost for the duration of the CFD and options contracts.
Contracts for differences are traded over-the-counter. This means that there is no central clearing involved and trades are settled directly.
It is different to how you would buy a stock, which usually goes through your broker and then to an exchange.
When you are going short on CFDs, you are essentially borrowing the CFD contract from the broker (for which there is a fee to pay). Upon closing this short position, you give back the shares to the broker.
When it comes to options, you have both over-the-counter as well as clear options that are available.
This makes some of the options similar to futures, which are also traded at an exchange.
Because some of the options (mainly equity options) are cleared and settled at an exchange, it incurs additional costs. Hence, options contract commissions are typically higher than a CFD contract upon trade initiation.
However, once you move into the exotic options area such as FX and credits, these are settled over the counter. But sadly, the retail trader cannot access these exotic options. The main reason being that OTC options demand higher trading volumes.
At times, the exotic options require a minimum of one million in trading notional, which is out of reach for most retail investors.
Having outlined the basics of CFDs and options, and then laying out the differences between the two, now comes the question.
Should you trade CFDs or should you trade options?
The answer to this depends on a lot of factors and mostly it boils down to one’s financial savviness. Options contracts are a lot more difficult to grasp than CFDs.
A CFD contract replicates the price movements in the underlying contracts. Hence, you can make use of the same technical analysis as you would when investing in a stock (besides using fundamental analysis).
With an options contract, you would need to focus on other aspects.
For example, an option contract is valued based on its implied volatility. Hence, there is various sensitivity analysis that one should consider. These are known as option greeks. Option greeks are a bunch of risk analyses for an option.
The option greeks are Delta, Vega, Gamma, Theta, Rho. Among these, Delta, Vega and Gamma are more commonly used. Traders also look at other option analysis methods such as the volatility smile and the moneyness.
These are somewhat difficult to grasp compared to plotting a price chart with technical analysis.
At the end of the day, traders need to use a financial instrument that they are comfortable with and understand how it works.
Both CFDs and options offer the same goal or hedging one’s risks.