Risk disclaimer: 76% of retail investor accounts lose money when trading CFDs and Spreadbets with this provider. You should consider whether you understand how CFDs and Spreadbets work and whether you can afford to take the high risk of losing your money.
CFD vs Options: Key Differences and How to Trade?
BY TIO Staff
|July 30, 2024CFD vs Options, what’s the difference and how to trade them? In this article, we will provide you with practical knowledge on both to help you decide which contract type suits your trading style. Let's start exploring the unique benefits of CFDs and options to boost your trading knowledge. We will cover the fundamental concepts, key differences, and practical applications of each financial instrument.
First of all, CFDs (Contracts for Difference) and options are financial instruments that allow traders to speculate on price movements without owning the underlying assets. In other words, they are derivative contracts whose value is determined based on the price movements of underlying assets like gold or the S&P 500. While both are derivatives, they have distinctly different characteristics, leading to varied uses in financial markets. Understanding these differences is crucial when choosing when to use CFDs and when to express the trade idea using options.
Understanding Options Basics
Options are financial derivatives that provide the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified timeframe. They are typically traded on exchanges as standardised contracts, ensuring consistency in terms and conditions across the market. The two primary types of options are call options, which allow the purchase of an asset, and put options, which allow its sale. Additionally, options can be classified as European, which can only be exercised at expiration, or American, which can be exercised at any time before expiration.
Options offer significant flexibility in trading strategies. Traders can use them for various purposes, such as hedging, speculation, and income generation. Common strategies include buying calls or puts, which involve purchasing options to gain exposure to potential price movements. More advanced strategies include spreads, where multiple options are combined to limit risk or enhance potential returns, and straddles, which involve buying both call and put options on the same asset to benefit from significant price movements in either direction. This versatility makes options a valuable tool for traders seeking to manage risk and capitalise on market opportunities. However, trading options during high implied volatility (IV) periods presents challenges. High IV inflates option premiums, increasing the cost for traders. More on this later as we study trade examples.
Introduction to CFDs
Contracts for Difference (CFDs) and options are financial derivatives that allow traders to speculate on price movements without owning the underlying assets. Both instruments provide leveraged trading opportunities, but they operate differently and are used for distinct trading strategies. When opening a CFD trade, a trader agrees with a broker to exchange the difference in the value of an asset from the contract's opening to its closing. CFDs can be traded on a wide range of assets, including stocks, commodities, indices, currencies (forex), and cryptocurrencies. This diversity provides traders with numerous opportunities to engage in different markets.
CFDs are particularly useful for short-term trading strategies, enabling traders to react quickly to market fluctuations. The flexibility to go long (buy) if expecting price increases or short (sell) if anticipating price decreases allows traders to adapt to various market conditions. Furthermore, CFDs offer leverage, allowing traders to control larger positions with a smaller amount of capital. This feature can enhance market exposure but also carries a higher risk of significant losses.
CFD vs Options: How Traders Use CFDs?
Traders use CFDs to speculate on the short-term price movements of various assets without owning them. This is particularly useful in volatile markets where quick price changes are expected. Unlike options, which require a premium to be paid upfront, CFDs provide a straightforward way to take advantage of market fluctuations. The CFD vs Options debate often centres on this aspect, as CFDs offer more direct exposure to price movements without the complexities associated with options' strike prices and expirations.
Trading Macroeconomic Data Releases
CFDs are employed to take advantage of economic events such as interest rate changes, political developments, or economic data releases. Traders can quickly enter and exit positions based on anticipated impacts on various asset prices. The CFD vs Options comparison in this scenario often highlights the agility and responsiveness of CFDs. Options may not always provide the same level of immediacy due to their structured nature and the need to manage expirations and strike prices.
This strategy involves placing buy and sell stop orders just before a macroeconomic data release. In this example from June 7th, 2024 orders are placed before Non-Farm Payroll (NFP) release beyond the recent 10-period high and low to capture potential volatility spike in EURUSD.
Protective stop loss orders are set at a safe distance to prevent triggering by minor market fluctuations. Position sizes are adjusted to reflect the distance between the trade entry levels and the protective stops.
As the Non-Farm Payrolls report shows 272K new jobs were created, beating the market expectation of 182K by a wide margin, the dollar rallies strongly, sending the EURUSD sharply lower. The order number two, a sell stop order is triggered and a short position is opened. The order to buy the market is not triggered and can be deleted. Traders use similar strategies when trading the risk events in general, leveraging event-induced volatility while managing risk through strategic order placement and adjusted position sizing.
Swing Trading and Trend Following
Traders use CFDs to speculate on the movement of entire market indices, such as the FTSE 100 or S&P 500. This approach is used by trend following traders who wish to trade broader market trends rather than individual stocks without the need to worry about the contract expiring or the time decay related to options.
In this example trade the S&P 500 index CFD breaks above the top of a bullish triangle formation on January 19th 2024. The market is bullish so trend followers and swing traders buy the market the next day. The breakout and the bullish sentiment in general attract more buying to the market resulting in approx. a 660-point rally over the next five months. Traders who expressed this trade idea using CFDs nstead of options did not have to take time decay or contract expiry but they had to pay an overnight financing cost to keep the position open.
Therefore, both order types have their pros and cons but to sum up: In the CFD vs Options comparison, CFD positions offer more flexibility as they do not expire, don’t experience a time decay and do not require choosing a specific strike price. This makes CFDs particularly attractive for trend followers or swing traders who aim to stay in the trades from several days to several weeks. Remember, however, that CFD positions are subject to overnight financing costs known as swaps.
CFD vs Options: Counter-trend trade in gold
CFDs are widely used for trading commodities like oil, gold, and silver. Traders can speculate on the price movements of these commodities without dealing with the complexities of physical ownership, such as storage costs or delivery issues. When evaluating CFD vs Options for commodity trading, CFDs provide a more straightforward mechanism to gain exposure to commodity prices, without the need to manage options' time decay and volatility considerations.
On Monday, December 4th, 2023, the gold market experienced a sudden rally after a period of trending higher. As the market extended to the upside, traders began taking profits. This action together with speculative counter-trend short selling resulted in the formation of a bearish rejection candle on the 8-hour chart. Note that, trading CFDs and options carries a high risk of financial loss, and it is important to understand these risks before engaging in such activities.
Traders often short the market once it breaks below the low of the rejection candle. The idea behind this strategy is to sell gold after the creation of a bearish rejection candle and aim for a support level, identified at $2008.58.
The market eventually moved lower, penetrating the $2008.58 support level four days later, resulting in a gain of approximately $58 per contract for CFD traders. Trading this setup with options, however is a bit more complicated as options traders must account for the impact of volatility on premiums. Given the high volatility following the spike in gold prices, implied volatility at the time of the market breaking below the bearish rejection candle is likely also high, driving up option premiums.
Therefore, if a trader decides to buy puts to express this short trade idea, they might not achieve the same expected gain as the CFD trader, since the option premium may not increase as anticipated. To understand this concept better, let’s examine it more closely.
CFD vs Options: Understanding High Implied Volatility
In options trading, implied volatility (IV) plays a crucial role in determining the premiums of options contracts. During periods of high volatility, as illustrated in the gold market example, options premiums rise significantly. While this can provide opportunities, it also introduces complexities for traders looking to capitalise on anticipated market movements.
High Implied Volatility (IV) and Option Pricing
When IV is high, the market anticipates substantial price movements in the underlying asset. This expectation leads to inflated premiums for both call and put options. For traders looking to buy put options, high IV means they are entering a position at a higher cost, which can reduce potential returns unless the asset moves dramatically in the anticipated direction. This phenomenon creates a higher break-even point, making it crucial for the underlying asset to move significantly (and relatively fast) to yield a similar outcome to a short CFD trade.
Delta Considerations
Delta, a measure of an option's sensitivity to changes in the underlying asset's price, becomes a critical factor. For put options, delta is negative, indicating that the option's price increases as the underlying asset's price decreases. However, when IV is high, the delta of out-of-the-money (OTM) puts is lower. This means the price of these options does not change as much for small movements in the underlying asset, which can limit the benefit traders receive from slight declines. To achieve substantial gains, the underlying asset must move significantly to push the option deeper into in-the-money (ITM) territory.
Risk and Reward Dynamics
- Risk: High IV increases the cost of options, meaning traders are exposed to greater risk for seeing potentially lower returns. If the underlying asset does not move as expected, the time decay (theta) can erode the option's value rapidly.
- Reward: The potential reward exists if the underlying asset's price moves significantly beyond the expectations implied by the current IV. However, small or moderate movements provide less benefit due to the high premium paid upfront.
CFD vs Options: Comparing Two
Let's compare two trades where the expectation of gold trading lower is expressed through different methods:
a) Buying Puts
- Scenario: Gold's price target is $2008.58, with an entry price of $2068.88.
- High IV Impact: The cost of buying puts is high due to inflated premiums. For example, a put option with a strike price near $2068.88 might have a significant premium, reflecting the high IV.
- Delta Consideration: The put option might have a lower delta, indicating that the option's price will not increase substantially unless gold's price drops significantly. This means traders need a considerable move in gold's price to see substantial gains.
- Risk and Reward: The high premium paid means that the breakeven point is higher, requiring a significant drop in gold's price to achieve profitability. If gold's price drops below $2008.58, the trader profits, but the initial high cost reduces net gains. Trading CFDs and options can result in substantial financial losses, so it's crucial to fully understand the risks involved.
b) Selling the Market Short Using a CFD
- Scenario: Gold's price target is $2008.58, with an entry price of $2068.88.
- Delta Impact: CFDs have a delta of 1, meaning their price changes exactly in line with the underlying asset. This direct correlation makes them straightforward for capitalising on anticipated price movements.
- Risk and Reward: Selling the market short with a CFD does not involve paying a premium upfront. The trader gains directly from any decrease in gold's price. If gold drops to $2008.58, the gain is straightforward to calculate: $(2068.88 - 2008.58) per contract sold.
- Leverage and Costs: CFDs often involve leverage, which can magnify both gains and losses. However, they also carry financing costs if held overnight, which traders must consider.
Conclusion
Although trading both CFDs and options carries a high risk of financial loss, and it is important to understand these risks before engaging in such activities, we hope that our CFD vs options comparisons help traders to decide which suits them. Both derivative types offer distinct advantages for traders depending on their strategies and market conditions. CFDs provide flexibility, direct exposure, and are suited for short-term trading, while options offer structured contracts with strategic versatility. By understanding the unique features of each instrument, traders can better manage risk and seize market opportunities. Ready to start trading? Register an account with TIOmarkets.uk, a UK-regulated broker, to explore these financial instruments and enhance your trading experience.
While research has been undertaken to compile the above content, it remains an informational and educational piece only. None of the content provided constitutes any form of investment advice.
TIO Markets UK Limited is a company registered in England and Wales under company number 06592025 and is authorised and regulated by the Financial Conduct Authority FRN: 488900
Risk warning: CFDs and Spreadbets are complex instruments and come with a high risk of losing money rapidly due to leverage. 76% of retail investor accounts lose money when trading CFDs and Spreadbets with this provider. You should consider whether you understand how CFDs and Spreadbets work and whether you can afford to take the high risk of losing your money
DISCLAIMER: TIO Markets offers an exclusively execution-only service. The views expressed are for information purposes only. None of the content provided constitutes any form of investment advice. The comments are made available purely for educational and marketing purposes and do NOT constitute advice or investment recommendation (and should not be considered as such) and do not in any way constitute an invitation to acquire any financial instrument or product. TIOmarkets and its affiliates and consultants are not liable for any damages that may be caused by individual comments or statements by TIOmarkets analysis and assumes no liability with respect to the completeness and correctness of the content presented. The investor is solely responsible for the risk of his/her investment decisions. The analyses and comments presented do not include any consideration of your personal investment objectives, financial circumstances, or needs. The content has not been prepared in accordance with any legal requirements for financial analysis and must, therefore, be viewed by the reader as marketing information. TIOmarkets prohibits duplication or publication without explicit approval.
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