Trade CFDs or Options?

There are similarities between trading CFDs and trading options. The first is they both provide leverage to the trader. Also, you don't need a large account to start with either. They both, in different ways, allow you to control a greater value of financial securities than you could if you had to buy them outright, and so they give you leverage of your money. They also have the advantage that it is as easy to make money from falling values as it is from rising prices.

Options

An option is also a financial derivative and there are many similarities with CFDs, but there are important differences between them. An option provides its owners the opportunity, but not the obligation, to buy the underlying asset at the strike price (agreed price) on a specific future date (the expiration date). To acquire a call or put option, a trader will pay an options premium. This will be forfeited if the underlying asset fails to reach the strike price by the expiration date.

A call option is used when the trader thinks the underlying asset will increase in value, while a put option is used when the trader thinks the underlying assets will decrease in value. Options are very flexible trading assets and a trader can benefit from both price increases and decreases. Call and put options can be combined in innovative ways to create risk profiles that are not possible with CFDs. Although options still have some attraction due to their unique strategies such as straddles and spreads, the fixed expiry timeframe is a drawback from a directional traderís point of view. With options, you have to correctly predict the direction of the market and the timing of this upward or downward move.

CFD Trading versus Options Trading. Which is best?

Both CFDs and Options are derivatives and both are leveraged instruments. CFDs are a more direct investment in the underlying asset and unlike put or call options, there are no costs involved except the CFD spread and finance charges on open positions.

However, CFDs and options diverge at this point. With options you pay a premium, either for a call or a put depending on your view of the market, and if the price swings in your direction, you can make a good profit. If the price stays the same, and assuming you didn't pay extra for an option that was already in the money, the option expires worthless and you lose your premium. If the price goes in the wrong direction, you again lose your premium, but your losses are limited to this.

To illustrate the differences between CFDs and Options, consider the shares of Facebook, which as of this writing are trading at $74.93 per share. A trader who thinks these shares will gain in value over the next few weeks can either buy a CFD on 50 shares or buy one contract of call options representing 50 shares.

The share price of Facebook has a possibility of going to zero and this will entail losses for the CFD trader. Even if the price moves below $70.00, this will cause the trader to incur losses, since the trader has to pay the difference between the opening and closing price of the contract. While for options, the maximum risk is limited to the amount that was paid for the options. If the trader bought one contract of call options representing 50 shares, the trader would only lose the initial investment if the share price fell.

If the share price for Facebook does not move a lot over the next few weeks and trades in a narrow range, then the CFDs trades will only incur a small cost (i.e. the CFD spread and possible financing charges) whereas for the options trade, this could entail loss of the premiums that the trader paid for at the start of the trade.

Option prices are derived from different components, many more than a CFD. The most important being the price of the underlying share (as with CFDs), but also by volatility, time to expiry, prevalent interest rate and supply and demand factors. The number and complexity of price indicators that options can demonstrate creates a lack of transparency in their pricing. The formula for correctly pricing options was awarded with a Nobel Prize! No easy feat, adding credibility to the complexity of the instrument. With this noted, it is easy to see that the price of an option can significantly vary to that of its underlying asset.

Which is the best product to trade?

The maximum profit for the CFD trade is higher for a given price increase in relation to the profit attained by the options trade. This relates to the premium paid for the option. With large price swings to the upside, the CFD trade will make more profit, as it is the difference in the value of the CFD, while the profit from a call option is usually a fixed proportion of the initial investment. The options position only becomes profitable if the underlying asset increases by an amount in excess of the premium. In the case of CFDs, the trade starts to become profitable once the underlying asset price increases by more than the spread, which is smaller than the premium.

On the other hand, flexibility is a key advantage of options. Suppose you buy a CFD on Facebook but the stock declines. CFDs are directionally rigid as you are committed to a price increase. Once you are in a long position and the stock changes direction, then you will lose money as you are committed to one direction per trade. With options, you can hold opposing positions, say a call and put option on Facebook simultaneously, and adjust your positions until a profit is realized. There are a wide variety of options strategies but their complexity in terms of use and pricing also represents a drawback. CFDs are much easier to understand and trading CFDs are much like trading the underlying asset. With options, there are fewer financial instruments to trade and this means there are more opportunities for traders in CFDs, especially for those who do not want to use complex strategies with options. CFDs are much more transparent and the complex pricing of options is quite difficult for many investors to comprehend.

CFDs are easier to understand. Their value is directly related to the underlying shares, and you profit or lose in direct relation to their price movement. As such CFDs have a much closer relationship with the price of their underlying asset. This means that analysis and valuation of your CFD portfolio can be done through examining the market of its underlying asset (eg stock). Information on listed shares is more widely available and analysis is plentiful and thorough. With contracts for difference, your initial margin would be 5% to 10% of the underlying value, so this is where you achieve the high leverage that you need to make a good profit.

If the price swings in your direction, you make as much as a shareholder would make, less some minimal interest charges. If the price stays the same, then you are down by the amount of interest. If the price goes in the wrong direction, you could be down as much as the shares declined, but you would be guilty of foolishly ignoring the slide normally one of the first things you should do when you open a trade is set a stoploss so that your position is liquidated with only modest losses if the trade is wrong.

One of the key differences is in understanding what you are trading. The CFD is transparent, with anyone who understands the stock market (or other market) able to comprehend what the trade is and the expected outcome. Options have a reputation for being rather more difficult, and a true student of options needs to know about the 'Greeks' in order to determine how the price may vary, and create the best profit opportunities.

While that can be learned, the other major problem with using options is the time factor. A contract for difference can be held as long as needed, even though there will be some interest charged for holding a long position. Options have built-in expiration dates, and if the expected move in the price of the underlying does not occur before expiration, an otherwise good trade may still result in the option expiring worthless because of timing. It is no problem for the CFD trader to hold on for another week or two until the move happens, and to benefit fully from their insight.

Simply put, the complexity of options pricing means they are priced as their own instrument and trading them means learning many new indicators. Since CFDs mimic the stock they are following, there is little information beyond standard stock market analysis that is required to trade them. If you do not understand option pricing and do not have a good grasp of option strategies, then it would probably be more suitable to trade CFDs.

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