Another popular derivative that is often contrasted with CFDs are options (options, not binary options). Designed to be traded on exchanges rather than with brokers, options differ in terms of the outcome they deliver to traders, and therefore the situations in which one or other instrument is more appropriate will vary depending on what you’re trying to achieve. Whereas CFDs are straightforward agreements to settle on the price difference between open and close, options are assets in their own right, giving the trader the right to buy an asset at a certain price in the future. As such, options can be traded directly, or applied by an end user to deliver a second tier of profitability.
What Are Options?
Options are derivative instruments which relate to underlying assets by giving the holder the option to buy at the face price, usually if it is economically viable for him to do so. The option is not like a future, which compels execution on the expiry date, but instead gives the trader the ‘option’ to decide whether or not to follow through with the trade. If the trader called it correctly, he can exercise his options to buy shares at below market value which can then be sold on to deliver an immediate cash profit. In the same way as futures are traded on exchanges, so too are options, and they provide a wide range of advantages for both speculators and corporate predators.
A good example of how options can be applied in a predatory setting is with those looking to mount a takeover bid. Buying up options in a company effectively allows investors to have their cake and eat it to a certain extent – without risking the full investment in the company, they can effective control a percentage of its stock when it becomes financially sensible to do so by effecting their options. Thus, for a fraction of the upfront investment, investors can build in a time window to see how results pan out, while locking in today’s (hopefully lower than future) prices.
Why Buy Options?
Options are bought for a number of reasons by both speculators and investors. As with the above example, options can be bought as a precursor to a takeover bid, or to give potential future influence over a company or asset without committing fully to the capital required to fund the purchase. Or, they can be bought and traded as an instrument in their own right, with speculation on the price of the option rather than concerning yourself with the price movements of the underlying markets. Or, they can be traded for a combination of reasons, and executed to exact the full extent of the leverage they inherently can deliver.
In essence, options deliver a number of similar benefits to CFDs in that they provide high degrees of leverage, are reasonably flexible, and can therefore be useful in hedging and as part of your wider risk management strategies. However, options are generally considered to be a less risky instrument because they have an inherent, ‘real world’ value beyond that of the CFD, despite the fact that they are intrinsically more complicated instruments to understand and execute sensibly. So, for experienced traders in certain situations, options may well represent a better reward-to-risk ratio than comparative CFD trades.
What Are CFDs?
Contracts for difference, or CFDs, are instruments traded between traders and brokers to settle on the difference in the price in an underlying market. They are, as the name implies, contracts for difference in the value in the underlying market between the price today and the price when the position is closed. In many respects, CFDs work functionally the same as a share transaction, or buying any other instrument in cash markets, except for a number of key legal differences and the role of margin and leverage which both come into play when trading CFDs.
What Are The Costs of Trading CFDs?
CFDs are relatively cost effective to trade, particularly if you’re trading intraday. Each CFD transaction is charged a rate of commission by the broker, applied as a percentage to the total trade value. Then, financing costs are applied to cover the cost of leverage on a daily basis, accruing overnight at LIBOR +/- X (where X equals the broker’s own variable), divided by 365 to give a daily rate of interest. Of course, if your position loses, you also have to worry about the costs of repaying leverage, which can have the impact of making any losses feel all the more substantial.
How Do You Make a Profit with CFDs?
Profits in CFDs are made by banking a positive difference between opening and closing price (or a negative difference if you’re going short), then deducting commission, financing costs and repaid leverage to show a return on capital. For traders who are going long, i.e. backing a CFD to rise in price, the CFD must become more valuable over time than when they bought it by a sufficient percentage to offset other costs in order for a profit to be made. The reverse is true of short positions, which rely on the closing price being lower than the opening price in order for a profit to be realised.
Advantages of Options vs CFDs
Opportunities for ownership: unlike CFDs, which have no standalone value aside from their worth as CFDs (and only with the relevant broker who has agreed to be bound by the instrument), options actually have a number of practical advantages, most notably that they provide the opportunity for future ownership at today’s prices. If today’s prices are as good as it gets, you can ditch the options and lose only what you put in to them. If tomorrow’s prices are vastly greater than today’s, your options are effectively as good as cash in the bank, assuming you execute them and bank the difference before the markets reverse.
Low Trading Costs: as compared to CFD trading, options have a much lower trading cost. This is because they tend to be inherently leveraged, rather than traded on margin like CFDs, although it is obviously possible to employ a hybrid of both strategies. These low trading costs enable traders to cost-efficiently take exposure to the relevant options market without incurring excessive financing or commission costs as may be the case with CFD brokers, and certainly the lack of overnight funding makes options far more useful for trading in the medium to long-term.
No Financing Costs: The lack of financing costs if a major advantage for options, which are designed to be held long term. Holding a similar position in CFDs would quickly begin to cost you serious money, given the extent of funding charges applied daily to CFD positions, and it is often the case that positions suffer from an artificially shortened lifespan as a direct consequence of becoming financially untenable.
Disadvantages of Options vs CFDs
More Complex: options are fundamentally more complicated instruments, both in terms of how they reflect the risks of investment, how reward potential is calculated, and even just how they are structured and operate. When it comes to Contracts For Difference, the general principle can be explained in minutes. When it comes to options, the general principles belie an absolutely minefield of intellectual discussion and debate, with applied mathematics becoming more central to understanding how they work. For most traders looking to make some money trading the financial markets, the research effort for getting into options is one that shouldn’t be underestimated.
More Ways to Lose: because options are sold at a separate premium and as a separate instrument to that to which they relate, they effectively pose multiple different ways of losing. The options can expire worthless, in which case the trader loses his initial investment. But there is a second tier of loss, which is that the price returns to much the same level as it was when the options were issued, in which case the premium paid for the options is wasted expenditure.
Less Transparent Instruments: Generally speaking, options are just much more difficult instruments to understand than CFDs. This manifests itself in a number of different forms, including the transparency of the calculations underpinning instrument value. With CFDs, you simply look at the price of the CFD, look at the price of the underlying market, and you can see some obvious similarities. You know virtually instantly whether you’re getting a good or bad deal. With options, this is never the case, and getting to the bottom of whether an option represents a good value investment is a much more complicated state of affairs.