Contract trading is popular in many financial marketplaces. As a trader, you can purchase a variety of contract types—and each comes with unique risks and rewards. To choose and execute the right strategy for your goals, it’s important to understand the differences between them.
Below, we’ve outlined the benefits and drawbacks of two popular strategies: CFDs and options trading.
Contract for difference, or CFD, trading is an agreement between the trader and the broker. In this contract, both parties agree to exchange a financial asset during the time frame between when the trade is opened and closed. This type of agreement doesn’t require that the trader actually purchase the asset—it simply allows them to profit or incur losses based on that asset’s movement.
For example, if an asset is in a strong uptrend, a trader may wish to buy 50 shares of that asset at $20 a share. Rather than paying the full amount to purchase the asset in question (in this case, $1,000), a CFD agreement allows them to pay just 5 percent of the asset’s value to open the contract. In this example, 5 percent of $20 is $1, so the trader would pay a total of $50 for 50 shares.
Benefits of CFD Trading
CFDs allow traders to gain access to assets and markets without bearing the entire financial burden of acquiring that asset outright. Because asset price isn’t an obstacle for entering into a trade, CFDs also make it possible to trade in diverse global marketplaces that would otherwise be inaccessible to causal traders due to financial constraints.
Unlike options trading, CFD trading allows you to benefit from the existing trend rather than predicting future price movements. Major benefits include low trading fees and simplified trade execution (because the asset doesn’t need to be acquired before making the trade). In addition to those benefits, CFDs have less borrowing and day trading rules, low maintenance margins, and typically have higher leverage.
Drawbacks of CFD Trading
When you enter into a CFD contract, you agree to reduce your opening position by the difference between the ask and the bid price (what’s known as the spread). This can curb your potential profit margin.
Just because CFDs have low maintenance margins doesn’t mean that they’re less risky. Low maintenance margins make it easy to access bigger trading opportunities, but greater profits also means greater potential losses.
Options are a derivative security, meaning that their value is based on the value of another asset. Purchasing an options contract gives you the ability to buy or sell an asset for a fixed price before a stipulated date. Similar to a security deposit or down payment, this contract essentially locks in the price you’ll buy or sell at in the future.
There are two basic types of options contracts: call and put options. Call options give you the ability to buy an asset at an agreed upon price before a specific date. Put options give you the ability to sell under the same conditions. By purchasing a call or a put option, you are entering into a long or short position based on your expectation for the market in question. For example, if you purchase a call option to buy a house in a new development in three years at $600,000, you’re purchasing that option because you think that housing prices will rise beyond that threshold in the interim years.
Benefits of Options Trading
The main appeal of options trading is that it allows for speculation rather than buying or selling the asset outright. An options contract isn’t a commitment to buy or sell, it simply opens up the option of doing so at a fixed price down the road. For large assets, this enables traders to avoid legal or regulatory restrictions related to owning the asset.
Options trading can also be a form of hedging, like in the colloquial saying, “Hedging your bets.” Hedging means investing up front to limit the potential risks and expense of a different investment down the road.
Drawbacks of Options Trading
Oftentimes, traders will use statistical analysis to help evaluate option prices and anticipate risks. Although statistical analysis can help inform investment decision, it can’t predict the future with 100 percent accuracy. Because options trading is solely based on predicting price movement (unlike CFD trading), this uncertainty introduces risk. By entering into an options contract, traders expose themselves to loss if the market moves against their expectations. Unlike CFDs, options contracts also tend to have high maintenance margins.
Making the Right Choice
As you choose between options and CFD trading, remember to think about the market as well as your own trading preferences. Not all markets are good candidates for contract trading. For instance, ranging or volatile markets are often too risky for options trades, which are based on predicting price movement.
As you weigh risks and rewards, it’s also important to think about how much you stand to lose in maintenance margins over your stipulated time frame. If you don’t end up buying or selling the asset by the stipulated date, how much money will you have lost maintaining that contract? Calculating these costs up front will help you manage risk and reward more effectively.
The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.