> Why Trade CFDs > The Argument for Options Trading against CFDs

The Argument for Options Trading against CFDs

Options Trading
Written by Andy

The popularity of CFDs undoubtedly lies within their constituency of providing enhanced exposure to the market at very small capital funding requirements. Their popularity is further enhanced by the direct correlation to the underlying securities price fluctuations.

Options by contrast, are priced on a myriad of contingencies. It is these variables within the pricing, exemplified via the greeks that complicates the true measure of risk being priced.

CFDs or Options?

The outcome, is, the preference of novice investor/traders to the more transparent [seemingly] pricing of risk via the CFD. However, this risk is not quite as clear cut as it first appears as we will see below.

The recognition of risk, the pricing of risk, the assumption of correctly priced risk, the management of assumed risk are the mandatory steps required, and if performed correctly, will result in a positive expectancy of risk adjusted reward.

CFDs are of course in the first instance designed for the gamblers that populate the financial markets, providing the big leveraged moves that get the adrenaline flowing for generally small capital.

If your strategy revolves around directional plays, there is no excuse for leverage, prior to consistent returns with common stocks over at least two market cycles [Bull/Bear].

If your strategy is non-directional, then Options would be the preferred instrument, [as Convertible Arbitrage requires large capital to implement successfully for example] but, would require the theoretical knowledge to be in place prior to practical implementation.

I would argue that at their best, options should outperform CFDs hands down when it comes to risk to reward, but to do this, the options environment needs to satisfy specific conditions, and where these conditions are not met, that other instruments including CFDs may be more appropriate, but not the other way around. What I’m saying is, given a general choice, options should be considered above CFDs.

One key variable though is the capacity and actual knowledge of the individual trader/investor. If you can’t develop a sufficient understanding of options to a level to trade them, then this effectively rules this instrument out of contention. However, in my view, if you can’t figure options out, I would have serious doubt about such a person using any kind of derivative product period. I’d tend to think they’d be better off getting someone else to manage their investments such as considering using a managed fund.

This may sound harsh, but if you don’t have the intellectual capacity to understand derivatives to this level, trying to use related leveraged instruments just doesn’t add up to me – either you’ve got the ability to learn or you don’t. So, I tend to agree with Wayne regarding which instrument to use, it all depends on the situation.

If you can’t trade a profit in a basic share portfolio basis then you’ll never trade a profit using CFDs.

The problem I have is that many CFD traders are not aware of their full exposure to risk, and often are not capable of evaluating the best instrument available to them based on their market view of a potential trade.

I’ve sat down with CFD traders and compared notes looking at the real risk to reward involved with a range of trades comparing CFDs and options and how they performed.

While sometimes good options trades are not available for a stock/index/commodity future/Forex (in which case perhaps using a CFD may be the better alternative in some cases), generally I have found that if you have sufficient options knowledge, options can significantly outperform CFDs in terms of risk to reward, if the appropriate strategy is available (sometimes appropriate options aren’t available maybe due to volatility problems, or liquidity/open interest, etc).

I went through one example with a trader (which was representative of the general findings overall) where the option slightly outperformed the CFD in terms of reward, but was about 5% the exposure – yes, that’s 20 times less exposed – than the CFD position. But each underlying and options market may differ significantly depending on a host of variables, so this comparison can vary widely.

So, I would argue that it is essential to fully understand all the instruments you are considering, and that the trader/investor develops the ability to assess the risk to reward proposition they are considering entering. That’s what using derivatives should be all about, minimizing risk in context with maximizing reward.

Sometimes a CFD will be the better alternative, but it is having the ability to assess which instrument is best based on the trader/investor’s style that ultimately separates the amateurs from the professionals.

Another issue is that many people using CFDs don’t understand their real exposure. If you’re using a 5% margin for collateral, which means that you are borrowing 95% of the full amount the position is worth.

So, for example, let’s say you enter long $50,000 worth of XYZ stock in CFDs while it is trading around $10, so your margin requirement is $2,500. Let’s say that overnight a major negative news event happens, and the next morning the stock opens at $5.00.

You’ve just lost around $25,000 if your position is closed (which will happen if your account is not big enough to put up the margin required), but thought you were risking $2,500 if you didn’t understand the real nature of the exposure which was $50,000.

Just think about how many people may load up several positions like this thinking all they need to do is leverage $2,500 at a time. What if the market moved significantly against them? It is very easy to be exposed to over $100,000 of risk if you don’t know what you’re doing.

Even though strong moves like this are uncommon, they do happen, and they are a real risk. I know a trader who lost over $100,000 in this way in under a month because he didn’t manage his positions, and didn’t realize his real exposure. All you need is one major loss to wipe out months of good trading… think about it.

Ok, so there are guaranteed stop losses (GSL) available for CFDs which can be used to limit risk, but this is usually set at a maximum 5% loss in the underlying, and often has a fee to establish one, and for some providers a fee to move the stop loss as the underlying moves. This is certainly preferable to being totally exposed, but can still leave the trader/investor exposed to considerable risk. 5% for each large position can add up very quickly.

Another issue about CFDs is the exposure to having your account cleaned out. This happens if a position moves against you, and there are not sufficient funds available to cover the growing margin requirement. I’ve heard of CFD traders having their account cleaned out on an intra day spike, only to see the stock rally up past where it opened and continue on in their direction. But if the account can’t meet the margin requirements at any time, the position is automatically exited at a maximum loss to the account. This is a real problem if it is not managed, and in my view a major disadvantage compared to options.

With options, there are a myriad of ways to control risk that are not available with CFDs. Firstly, even using a simple long call or put, the risk is limited to the initial premium (plus OCH fees and brokerage). You can’t lose more than you paid. Then there are a range of spreads available to cap risk, each with application depending on the market conditions.

Secondly, there are no interest payments required on a long position (or a short one for that matter – although you can receive interest from CFDs for short positions) like there is with CFDs. Certainly, there is time decay, but this can be managed, and ameliorated, or even utilized using various options approaches (sold options suffering time decay are helpful to the seller).

Thirdly, if you buy a put for a bearish position, you don’t owe the dividend at ex div like you would if you were short the underlying with CFDs (Of course if you were short a call that is assigned before ex div, you would owe the dividend).

In addition, options are regulated instruments with significant underwriting, where CFDs are essentially an OTC (over the counter) instrument, and there is a risk that the CFD provider could become insolvent, and part or all of the trader/investors’ funds may be lost in this event.

So, some key issues are based on your view of the market, how long you intend to be in the position, and what the best risk to reward strategy is available balanced against the probability of success.

Add another dimension of a range of other instruments available such as futures, warrants, forwards, swaps, bonds and debt notes, and other instruments such as convertible notes, and you have a smorgasbord of choice. The challenge though is developing the capacity to evaluate all these instruments, and then effectively evaluating the best risk to reward approach with the best probability for success.

While I understand when I hear the response that CFDS are ostensibly simpler than options, I would argue that in the broadest perspective that this is a misconception. CFDs are actually more complex than they seem. Sure they are perhaps less complex than options, but they’re quite dangerous in the wrong hands, and certainly less flexible, and arguably can be much more exposed to risk. Sure, it’s harder to work out an options strategy at first, but if you don’t do the due diligence, you’re really leaving yourself open to potential ruin.

Obviously CFDs have their place as well. The main advantages for me are smaller spreads and being able to close a position in the morning at open, without having to wait for Market makers. I’ve been stuck with options a few times when there has been no market and hence no way to offload a losing position.

If you’re trading way OTM positions, you have to accept that heavy losses will occur when you get it wrong, and be comfortable with this (hence considering small positions for single options series). Using CFDs in these situations may be preferable, and it is up to the individual to evaluate which approach to choose based on their style and risk profile. And you don’t always have to trade directional strategies.

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