CFDs And Options: What You Need To Know
CFDs and options are both classified as derivatives, which means they are financial instruments that derive their value from underlying assets such as stocks.
Investors in CFDs and options do not actually own the underlying assets but can benefit if the value of those assets goes up or down.
There are two main reasons traders use derivatives: because they provide opportunities for leverage (i.e. using a small amount of capital to obtain an interest in a large amount of value) and because they can be used to hedge (i.e. manage risk).
Both CFDs and options can potentially generate significant profits for investors. But they can trigger major losses, too, particularly for traders who don’t understand how to use them.
That’s why it’s critical to understand how both instruments work.
What is a CFD?
A CFD, or contract for difference, is an agreement between an investor and a broker to exchange the difference between the current value of an underlying asset and its value at contract time.
In other words, a CFD allows the investor to make a prediction about the future value of an asset without buying or selling that asset.
CFDs can be used to profit either from an increase in the value of an asset or from a decrease in value.
If a trader buys CFD and the underlying asset’s value increases, the trader profits. Likewise, if a trader sells a CFD and the underlying asset’s value decreases, the trader receives the net difference.
What is an option?
Options are agreements that give buyers the right to buy or sell underlying assets at a set price and time but do not obligate them to do so.
There are two main types of options: call options, which give the holders the right to buy assets, and put options, which give the holders the right to sell.
As the name implies, traders purchase these agreements to give themselves options in the future. If you are certain an asset is about to rise or fall in value but you are unwilling or unable to trade it, an option is another way to take a position.
What are the advantages and disadvantages of CFDs?
CFDs allow traders to take a position on the underlying asset using a relatively small amount of capital.
As well as being cheaper, this strategy creates leverage, which means your profit from a CFD in percentage terms could exceed the profit you would make by trading the underlying asset.
However, leverage can lead to larger losses, too. If the value of the underlying asset doesn’t move in the direction you hoped it would, you could end up losing more money than you would have if you had traded that asset.
There are a couple of other noteworthy advantages to trading CFDs. Firstly, the products can be bought and sold relatively quickly. That’s because no assets are actually changing hands, meaning deals can be completed faster.
Secondly, CFD markets are not bound by the minimum-capital rules that govern day trading on most other markets.
What are the advantages and disadvantages of options?
Options also present opportunities for investors to leverage their positions.
Let’s say you buy $1000 worth of call options instead of spending that $1000 on the underlying asset. If the value of the asset increases significantly, you then have the option to buy a large amount of the asset at below-market price.
If you had simply spent the $1000 on the underlying asset, your net profit would be much lower.
Another reason options are popular is because they allow you to ‘lock in’ an attractive price for an asset, even if you don’t have the capital available to purchase it immediately. You can subsequently buy the stock or simply move on.
Options appeal to many traders. But you can lose money if you buy an option and the value of the underlying asset doesn’t go your way. If that happens, the option is effectively worthless.
CFDs: an example
Say Tesla is trading at $99.98/$100 a share. You believe the share price will soon increase, so you decide to go long.
The cost of each unit is calculated as a percentage of the share’s current value. This is known as the margin rate. Let’s say the margin rate for this CFD is 5%. That means you can take position on $25,000 worth of Tesla stock, or 250 shares, for an outlay of $5000.
In one hypothetical outcome, the Tesla share price does rise and by the end of the contract period it is worth $110/$110.02 a share. You close your position and receive $10 for each of your 250 units, a profit of $2500 (minus fees).
Another outcome could be a reduction in Tesla's share price. If, by the end of the contract period, shares are only worth $90/$90.02 a share, closing your position would result in a loss of $10 for each of your 250 units or $2500 (plus fees).
Options: an example
Say the Commonwealth Bank (CBA) is trading at $50 a share and you believe the price will soon rise. You decide to buy a call option so you can lock in the current price.
The premium is the price of the option, set by buyers and sellers in the market and the strike price is set stated on the option, which is the purchase/sale price of the underlying asset or index.
Let’s say you purchased 10 call options representing 1000 shares with a strike price of $60 per share. The total premium payable is $200, or the equivalent of 20 cents per contract. Each option (known as a contract) costs you 20 cents.
In this example, the CBA share price does rise during the term of the option to $70. You can now buy 1000 shares worth $70 each for $60 a share. In effect, your option has intrinsic value of $10 per share or $10,000. You end up with the option to buy $60,000 CBA shares (1,000 at $60) that would have a market value of $70,000 with the CBA share price at $70.
However, if the share price falls, using your contracts would cost you more than buying without them. The $200 you spent on the option is effectively lost.
What’s the bottom line on CFDs and options?
Derivatives such as CFDs and options present significant potential to build wealth. However, trading them can also lead to large losses, even if you understand the principles that underpin them. Remember: you don’t own the underlying asset.