CFD Trading versus Options

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CFDs versus Options Trading

Q.: Comparing Listed CFDs to other derivatives and Commodities directly what outweighs the other, risk out of the way?

A: A listed CFD (also referred to as a TURBO) is a contract for differences traded on the London Stock Exchange (Contract for differences are traded on OTC markets).

SG Corporate & Investment Banking (SG), part of the Société Générale Group is the only issuer of Listed CFDs I know of. They make their profit from the spread, which is substantial on some LCFDs if you're trying to make a quick trade.

However, Société Générale typically immediately hedge your trade in the markets by mimicking your position in the actual market. Hence I don't believe they profit from your loss. Issuers will make profit from high volume/turnover in their derivatives, through the spread . It seems listed CFDs are nothing more than DMA CFDs except that they have a guaranteed stop and aren’t currently very liquid.

You cannot lose more than you invest, even on a short trade. This is because the stop-loss will terminate your position, often leaving you with still some cash at the end. The guaranteed stop-loss is the final frontier and will terminate your trade leaving you with very little or nothing (of course it all depends on your trade).

Take the case of a Long PartyGaming Listed CFD for example. The entry level of this contract is 220p. This entry level (220p) acts as a guaranteed stop meaning that you cannot lose more than your initial margin payment even if the market continued to move against you beyond this level. If PartyGaming were trading at 240p the price of the CFD would be 20p. If PartyGaming were to increase by 5p then the price of the CFD would increase accordingly and the contract holder would make 5 pence per contract. Listed CFDs also have a stop loss attached to them (as well as the guaranteed stop). Suppose the stop loss of the PartyGaming contract is set to 230p and if this was hit the contract under normal market conditions the contract would be automatically closed at this level. If PartyGaming were to issue a profits warning the price might gap down to 180p but in this case the guaranteed stop would set in at 220p. Turbos (i.e. Listed CFDs) have a fixed expiry date so the financing charges are built into the price like a futures contract. The price of the Listed CFD always reflects the remaining finance costs to expiry so that whenever an investor closes their position they will only have paid the costs relevant to their holding period.

Listed CFDs are still high risk - high reward, like other derivatives. Only get into them if you know what you are doing and are an experienced trader/investor. Deal in small positions at first to facilitate your learning.

Q.: What are your thoughts on options?

A: An option gives you the right but not the obligation to buy or sell a fixed amount of a share/future/currency...etc at a specified future date. Buying an option limits your risk to the premium you pay. When selling an option you get exposure similar to going short but its value is also dependent on a number of other factors, in particular the change in price of the underlying asset (delta) and time value (since options have an expiry date).

If you are buying call options it is very important to know the period when the most time wastage occurs. That is the period where the writers make money out of the buyers. This can be such a fierce drop that it is probable that the unwary may well only breakeven when the actual share price is taking off and, if the price does not move, the option price will fall to the level of the price itself, say from 60p right down to 2p!

The usual bait offered to new traders is 'You always know the maximum that you can lose'. However, the problem is that calls bought without due planning will almost always lose. Knowing in advance how much it will be is no help!

Just take care with options trading, I've had my ups and downs with them and finally left for the straight futures markets.

Another personal opinion, if I may. Decide what is going to happen to a share price, select the option carefully (with plenty of time value on it and well into the future so that you can sell before the wastage starts to come in - you'll get to know when that is, with experience) and buy it without going into all the straddles, butterflies, calendar spreads...etc. Those strategies sound good because they limit your losses more. The problem is that they also cost more in brokers fees, making it even more difficult to make money, in many cases actually putting a cap on what can be made.

You can also buy options when most of the time value has run out, say the last few days of its life.

I have William F.Eng's "Options - Trading Strategies That Work" but, I repeat. I found that my best trades were straight, simple, buy and sell operations of one option.

Q.: Are CFDs in the UK the equivalent of what options are in the USA?

A: Not really, contracts for difference are more akin to futures. Options are more complex instruments, that most importantly, enable investors/traders to speculate on or hedge against VOLATILITY. Options are also traded in Europe. Contracts for difference, however, are not currently permitted in the USA.

Q.: What about using CFDs in conjunction with options to minimise the risk?

A: You probably have heard of a 'covered call' strategy. This involves buying shares and writing (or selling) call options simultaneously over the same amount of shares. In the USA, this would involve multiples of 100 shares.

The important point about this strategy is that the written call options are 'in the money'. Which means that you want the prevailing market price of the share to be above the strike price of the call options, at the time of entering the trade. Let's see how this strategy work with shares. Let's assume the price of ABC stock is currently $61.35 and you decide to buy 1000 shares and sell 10 X $60 call option contracts at the same time for which you receive a premium of $4.90 per contract, or $4,900. Simultaneously you buy 10 X $60 option contracts at $3.10 per contract (they are 'out of the money' therefore less costly) which costs you $3,100. The net credit is $1,800.

As you can see the difference in option premiums above is $1.80 but the difference between $61.35 and $60.00 strike price is just $1.35. The 45 cents therefore represents immediate locked in profit, no matter the outcome.

Suppose, that by expiry date, the stock price has risen to $65. Your bought put options will expire without value while your sold call options will be $5,000 in the red. But your purchased securities will be $3,650 in profit. The difference between these two is a net $1,350 loss. But you have received $1,800 credit from your option strategy so you still stand to make an overall $450 profit, less commission costs.

Note that call options are usually more expensive than put options since their upside future intrinsic value is unlimited, whereas the intrinsic value in put options is capped to the difference between the current share price and null. However, given that you understand implied volatility in options, you will realise that this may not always be the case.

Using Contracts for Difference with Covered Calls

Before we look into this strategy beware that options and contracts for differences are two different products, with different behaviour and trading characteristics. One of the most significant is time decay with the option.

This contracts for differences/option strategy is one that certain people in education programmes/seminars suggest as downside protection for a long CFD position (instead of a stop loss) and that it is essentially a 'risk free' strategy. The strategy calls for buying a put option to cover the number of long CFDs traded plus some 'extra' put options to cover costs. The idea is that if the stock price falls then you simply sell the Put to recover your costs and loss on the CFD. If the stock price rises then you make a profit!

In the above example, you would probably think that $61,350 is a considerable amount of money to put into shares for a small $450 gain at option expiry date (about 1% return). The other way to do it would be using CFDs which would allow you to magnify returns.

Since CFDs don't have fixed expiry dates you can take advantage of this by going long 1000 ABC stocks CFDs at $61,35. Basically you would do exactly as outlined in the shares example but since you would be doing this with CFDs (which are traded on margin), instead of $61,350, you may only need to deposit 5 percent of the overall share value, which is $3,068 (you will also need to add broker fees and interest on the remaining 95 percent for the duration of the trade). Again if the security price goes up to $65 your contracts for difference position would gain $3,650, which substitutes the stock profit mentioned earlier. A guaranteed profit of around $400 after brokerage on an outlay of $3,650 is about 31 percent return on investment, per option expiry cycle, 'theoretically' risk free.

Unfortunately, it is far from risk free. If you are not careful you can be lulled into a false sense of security by not taking note of costs and price movements. If you buy the CFD and Put option then you have costs for both.

For a CFD you have to include round turn commissions and long interest. For options you have to include cost of the Put option itself and commissions.

There are three scenarios: 1. stock goes up. 2. stock goes down. 3. stock goes sideways.

If the stock goes up there is a stock price at which you would cover your option cost (price of option and fees). This price I call the 'upside threshold'. If the price continues to rise past upside threshold then you are theoretically 'in net profit' with your CFD. However, if the stock doesn't increase much further than the threshold you don't make much (if any profit) and the cost of the option has effectively neutralised any profit you would have made by only trading the contract for difference.

If the stock goes down there is also a 'downside threshold' this is the price that the stock must fall to fully recover your option costs and recover the loss in the CFD. A further fall in stock price below this 'downside threshold' will result in more profit. Again, however, if stock price doesn't fall too far below this threshold then you will make little if any profit.

If the stock goes sideways - that is at prices between the upside and downside thresholds then you can lose quite a bit of money. More money can be lost in this 'twilight' region than setting a sensible stop loss, because you are unable to cover the full costs of the strategy.

You should also consider the following about options

Can you get an option with the term and strike price at or near the price of the CFD? A price too far away from the price of the CFD would make the strategy even more risky.

Can you sell the Put at the price you want? The options market isn't as liquid as the CFD market.

If you use this strategy then you will have to do the calculations to determine the upside and downside thresholds and avoid the 'twilight zone'!

Q.: I have seen mention of the Greeks in options...but what are they?

A: To understand what factors affect the pricing of an option requires learning about the so-called 'Greeks' which are (as the name implies) derived from the Greek alphabet. These are quantifiable factors that indicate to what extent an option is exposed to time-value decay, implied volatility and changes in the underlying price of the commodity. The Greeks consist of Delta, Gamma, Theta, Vega and Rho. Delta - The ratio comparing the change in the price of the underlying asset to the corresponding change in the price of the derivative.

Gamma - The rate of change for Delta with respect to the price of the underlying asset.

Theta - Represents the rate of change between an option's value and time (time sensitivity).

Vega - Represents the rate of change between an option's value and the underlying assets volatility (volatility sensitivity).

Rho - Represents the rate of change between an option's value and interest rates (interest rate sensitivity).

Q.: A CFD seems to be very much like a single stock futures contract, what's the difference?

A: A contracts for difference is basically an arrangement made in a futures contract whereby differences in settlement are usually made through cash payments as opposed to the delivery of physical goods or securities.

A CFD over a share has no expiry date. CFDs can also be taken over indices, currencies and options - most of these instruments track the underlying futures contract and thus have expiry dates.

Q.: What are Binary CFDs?

A: Binary CFDs also referred to as binary bets (binary betting) are practically nothing more than fixed odds bets on the financial markets. They were introduced in March 2005 by CFD issuer IG Markets and a binary CFD simply represents the probability on a directional movement happening or not – such as the market finishing up or down on the day. IG Markets quotes a price on that probability of between zero and 100. If the event occurs – in this case, the S&P/ASX 200 Index closes higher on the day - the trade settles at 100; if the event doesn’t occur - the index closes lower - the binary settles at zero. Binary CFDs are also quoted on other share market indices, as well as currencies and commodities.

Q.: Are CFDs better to trade than options? Should I trade CFDs instead of options?

A: The thing you should do is to stop comparing CFDs to options. They are different financial instruments. I have seen CFDs compared to options with people saying: "CFDs have no time decay." Well of course they don't, because they are not options. In fact the only similarity between CFDs and options/warrants is that both are leveraged instruments.

Options trading can be a low risk hedge or alternatively a speculative trade. Options are an over-the-counter and an exchange product. CFDs are an over-the-counter product specific hedge or speculative tool. CFDs a great for pure directional trading. Options allow you to trade non-directionally.

How then should one look at CFDs? The best way to look at CFDs is to compare them to a position in the underlying itself. So Telstra CFDs are comparable to Telstra shares. Trading in a Telstra CFD will give you an equivalent price exposure to Telstra shares, but when you buy the CFD you do not own the shares. You own the CFD. In this sense, you can think of it as a synthetic security. CFDs also allow you to short sell the underlying and can pay you interest on the amount you should sell. (Interest is paid because with short selling you are effectively lending the security to someone else. You should therefore be paid for it).

As a comparison to options however...well they don't compare. There are dozens and dozens of different (and sometimes complex!) options strategies one can place. With CFDs you can be long, short or flat. That's it. And don't forget that an option in the UK is 1,000 shares rather than 100 (as in the States) and things finish on the 3rd Wednesday of the month (rather than the 3rd Friday).

If you are undecided about which instrument to use, ask yourself 'What if I am wrong?'. How much will you lose using cfds compared to options? Then look at the recent chart of RMTC and do the sums.

Let's assume you want to buy XYZ Ltd and at the time it is quoted at 99 cents (bid) to $1 (offer) and that you are looking to buy 10,000 shares, as a contract for difference, at the offer price. You will require an initial margin of $1000, or 10 per cent of the value of the trade. While your position remains open, your account is debited each day for interest. In table 1 (see bottom of page for link), for example, the applicable interest rate is 7 per cent.

However, if you took a bearish view and opened a short CFD, also held for six days, and you got the price right, the interest amounts would be credited to your account and the result would look like table 2.

CFDs are not suitable for "buy and forget" trading or long-term positions. Each day you maintain the position it costs money (if you are long), so there is a time when CFDs become expensive. For short-term trading they have advantages, provided you get the markets right. But be prepared at some economic stage to cut the position.

See example here for the long and short CFD trades

Contracts for difference are much more straightforward and transparent than other equity derivatives exchange-traded options (ETOs), warrants, and individual stock futures (ISFs). The problem with options and warrants and even futures is that they are all priced in quite a complex way, which is quite difficult for many investors to grasp. Options and warrants also incorporate the concept of time decay: you’ve got to understand delta, gamma, theta and vega, which are all measurements of various aspects of the relationship between the price of the underlying asset, the price of the derivative, and time.

Q.: I’ve heard about a strategy where one trades CFDs using puts?

A: I think the scope of a strategy where put options are implemented alongside CFDs is because CFDs effectively have unlimited loss potential. The put option is bought separately to the CFD to increase in value if the CFD goes into loss territory (if you have gone long). Add the multiplier effect of CFD trading together with the creative use of options and you have an interesting trading model...

Q.: What do you think about writing covered calls, while short selling the stock as a hedge to your position?

A: By buying the stock and then selling CFDs simultaenously it technically (aka synthetically) closes the stock position so that you have the same risk as a naked sold call.

Admittedly, you can place a stop loss on the CFD if BHP goes up strongly, but that would be the same if you simply had the naked short call and decided to buy the shares at that same point.

Using your suggested strategy, if BHP went into a trading halt and then gapped up strongly, your short call would still cause similar losses to a naked short call at that same strike.

Sadly, there's no free lunch or easy way to collect premium by means of theta decay - there is usually always a risk lurking somewhere no matter how creative we become. Depends how much risk you are willing to take on for a little premium.

The only ultimate protection I can see is to buy your stock i.e. buy a put to protect its value...and then write calls against the stock. The cost of the put might take 75% of potential annual premium if you write it at the money - or you can opt for a lower priced put.

Some have done 'collars' - this is where you buy stock and lower (otm) puts to offer some protection for the stock and then sell calls. It is a bullish to neutral strategy and generally can still lose more on the stock than can be replaced by the selling of calls - especially in the strong down conditions we have had recently. It is much the same as a bull call spread with a slight difference in the cost of carry (interest).

 ...Continues here - CFDs versus Warrants