Derivative trading: options versus CFDs

Options contracts and CFDs are both derivative markets that can be utilized to trade a variety of financial instruments. However, there are key differences between the two markets and arguably, one might be more advantageous than the other.

Derivative trading: options versus CFDs

While trading fx options with a trusted broker may prove to be profitable eventually, if you are looking for easier ways to take advantage of the opportunities available in forex, you may want to rethink your investment strategy. Forex options take advantage of the high liquidity in the forex market but with CFDs (contracts for difference) you get greater flexibility, more competitive pricing and the learning curve is much lower.

Both options and CFDs, however, are derivative assets which means that their value depends on the underlying asset which they track. Therefore, the performance of the underlying asset will dictate how well your options or CFD trades are performing and you can trade options and CFDs in a variety of asset classes including stocks, forex and commodities as well.

Besides CFDs and options contracts, you can trade other derivative markets such as:

  • Futures
  • Swaps
  • Forward contracts

 

Differences and similarities

Both markets have some differences and similarities, but options and CFDs offer distinct advantages to suit the objectives and requirements of different trading strategies.

For instance, with options, you have the capability to buy or sell the underlying asset on a predetermined date as per your contract. However, you pay a premium just for the privilege of doing so for a limited time. If your speculation is correct, you will receive back a part of the premium.

As such, in terms of potential profit, CFD trading will always be more advantageous due to the fact that the cost of trading is much lower since there is no options premium equivalent. The cost of a CFD trade depends on the difference between the Bid and Ask price. For example, if you want to trade a CFD in facebook stocks and the current going rate is 188.91/188.97 – the price on the left being the Bid and the price on the right being the Ask, you will only be liable to pay this 0.06 difference to your broker as the spread. There is no additional premium on top of the broker’s spread as is the case with an options contract.

Also, unlike options, CFDs mirror the performance of the underlying instruments. If the value of the facebook stock increases by $10, the CFD will reflect this change. On the other hand, options contracts have a more complex pricing structure and there are several factors that can drive their price. The intrinsic value of a stock, its volatility and the expiration date of the contract are all taken into consideration.

Another advantage of CFDs is that they do not have an expiry date and therefore a position can be left running for as long as you have enough trading capital to sustain it. Therefore, theoretically, you can keep a position open until the market moves in your favor and only close the trade when you have realized your profit targets. Depending on the exchange rates between the instruments you are trading, you may be liable to pay interest or receive interest as well.

So, with a CFD trade, you can buy 100 shares of Facebook stock and even if the price drops for a limited amount of time, you can wait until it bounces back to higher levels before closing the trade or selling back the shares to realize a profit. However, in doing so, you bear the risk of the trade being automatically closed by your broker in case the price depreciates to the point where there isn’t enough capital available in your account to sustain the potential loss.

 

The better market

This is quite a controversial subject since both options and CFDs are favorable markets for experienced traders but it’s clear that CFDs are simpler and more accessible for traders of all levels of knowledge and experience.

The CFD market is more diverse and there are thousands of underlying assets available for trading. The market provides more competitive pricing and leverage and the potential profit is virtually unlimited but so is the exposure to risk. There are tools available to mitigate said risk within the trading platform but since forex is a volatile market, it is imperative that you manage your position size accordingly in order to protect your account from extreme market conditions.

A certain degree of volatility is always favorable for traders in the derivatives markets since investors speculate to make a profit from the difference in the price of the contract. If there is no movement in the underlying instrument, then there are no profitable trading opportunities. In an options contract, where there is an expiration date for the price to reach your target, you are even more pressed for time. If there is no significant event to move the market in your favor before the contract expires, you will lose the trade even if eventually you were correct in your market analysis.

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