CFDs vs options: what are the differences?
CFDs and options are both financial derivatives that enable you to speculate on the markets, but they operate in very different ways. Here's a complete guide to the differences between the two.
What’s the difference between CFDs and options?
The difference between contracts for difference (CFDs) and options trading lies in how each contract works. In a CFD, you're agreeing to exchange the variation in the price of an asset from when you open your position to when you close it. With an option, you're buying or selling the right (but not the obligation) to trade an asset at a fixed price.
Traders can use both to go long and short on financial markets without taking ownership of any assets. But they fit different strategies, require different skills to trade and come with their own unique rewards and risks.
CFD trading basics
A CFD is a financial derivative in which you agree to exchange the difference in an asset's price from when you open your trade to when you close it. You can buy a CFD to speculate on upward price movement or sell one if you think a market’s price is heading down. How much you make or lose on each trade is determined by how much the underlying asset moves.
Say you believe that Apple stock is going to go up from its current level of $290, so you buy an Apple CFD. If you close your position when Apple is above $290, your CFD provider will pay you the difference in its price from when you opened your position to when you close it. If Apple's below $290, you'll have to pay your provider the difference.
Alternatively, you could have sold your Apple CFD at the outset. If you sell Apple at $290 and close your position at $280, you receive $10. If you close it at $300, you lose $10.
Like traditional stock trading, you pay commission to open a share CFD trade. So you'll need Apple shares to move by more than the costs of your position to make a profit.
Open a live IG account to start trading CFDs today.
Options trading basics
An option is also a financial derivative, and also takes the form of a contract. But instead of agreeing to exchange the difference in an asset's price, you're buying or selling the opportunity to trade it at a fixed price for a set period.
Let's return to our Apple example. If you believe that Apple stock is going to go up from its current level of $290, you might buy an option that enables you to purchase it at $295 at any point in the next month. If Apple rises above $295, you can exercise your option and buy it at a reduced price.
To get the option to buy Apple at $295, you'll pay a premium. If your option never becomes profitable, you can let it expire and the premium is all you’ll lose. But you’ll need to make more than the cost of the premium for the trade to earn a profit.
When you buy an option that turns to profit as the underlying market rises in value, it’s referred to as buying a ‘call’ option. But you can also use options to go short – these are called ‘put’ options. Buying a put enables you to sell a market at a fixed price for a set time. When you buy a call or a put option, your risk is fixed at the option premium (the cost of buying the option).
As well as buying options, you can sell them (known as ‘writing’ them). If you write a call, you open a short position. If you write a put, you open a long position. You’ll receive a premium when selling an option – but your risk is potentially unlimited.
An option’s premium will move up and down to reflect the likelihood that the contract will become profitable before it expires. This enables traders to use them to speculate on markets without ever exercising their contact and taking ownership of the underlying asset.
Find out more about how options work, or open a live account to start trading them now.
Benefits of CFDs
Similarity to the underlying market
CFD trading is designed to mimic trading each underlying market relatively closely. Buying an Apple CFD, for example, is equivalent to purchasing a single Apple share. Trading a GBP/USD forex CFD, meanwhile, is the equivalent of buying £100,000 in US dollars.
CFD prices are only driven by the movements of the underlying market. Our Apple CFD moves up in price as Apple’s share price increases, and down as it decreases. All other CFDs work in exactly the same way.
Option premiums, on the other hand, are driven by more than just the price of the underlying asset – they’ll also take the time to expiry and any underlying volatility into account.
Spot CFDs have no expiry dates – you can leave positions open for as long as you want. With options, your contracts can expire and become worthless.
As an option moves closer to expiry, its price will drop. This is a process known as time decay. So your positions may naturally diminish in value over time. With CFDs, time decay isn’t an issue.
You only have to put down a percentage of your total CFD trade to open a position. To make a trade on the FTSE 100 worth £5000, for example, you might only have to put down £250. So you can free up your capital for other investments or trades.
Choice of markets
You can use CFDs to trade a huge range of markets. IG CFD traders, for example, get access to more than 17,000 assets across shares, indices, forex, commodities and more. Most options brokers will provide far fewer markets to trade.
With IG, you can even use CFDs to speculate on option prices. Instead of giving you the right to buy or sell a market at a set price, option CFDs enable you to go long or short on the movements of option premiums. You can trade CFDs on daily, weekly, monthly and quarterly options.
Benefits of options trading
When buying a call or a put option, your risk is capped at the price you paid for the premium. If the underlying market swings in the opposite direction to your trade, you can just let your option expire and you only lose the premium (although this is not the case for selling options). In a CFD trade, your losses will grow as the market moves against you.
While your risk is fixed when buying options, you can still benefit from leverage. This is because the cost of buying options can be a fraction of the cost of buying or selling the underlying assets, yet any profit is calculated according to the size of the movement in the underlying market.
However, you should note that the risks involved when writing options can be much greater. This is because your profit will be limited to the premium you receive for selling the option, while losses can be unlimited if the market moves against you.
You can use a mix of call and put options – or of buying and writing contracts – to unlock advanced trading strategies. A straddle, for example, involves buying a call and a put option simultaneously on the same market. If the market moves in either direction, you can earn a profit.
Some strategies enable you to trade on volatility instead of price direction, or even speculate on flat markets. CFDs don’t give you the same level of flexibility – unless you use option CFDs.
Many investors use options to hedge against potential drops in their portfolio.
Say, for example, that you own 100 Microsoft shares. You're worried about a possible upcoming market crash, but you don't want to sell your shares just yet.
You could buy a put option to sell 100 Microsoft shares at their current level, reducing your losses if Microsoft crashes. If the stock doesn’t fall, you just lose the premium you paid for the option.
You can also use CFDs to hedge, however. In this example, you could sell 100 Microsoft share CFDs. Then, any fall in your portfolio will be cancelled by a rise in your CFD position.
CFD vs options trading: which is best?
Whether CFDs or options are better for you depends on what you're looking for as a trader. You can use CFDs to trade a much broader set of markets, so if choice is important to you, then you might prefer to start with CFDs.
CFDs are also more transparent than options trading, as their price moves one for one with the underlying market. If you’re already familiar with how financial markets work, then you will likely have a basic grasp of CFD trading. To trade options, though, you’ll need to do a bit more learning.
The extra factors that can move options prices almost make them their own distinct asset class. Understanding the Greeks, for example, can be beneficial as they determine how sensitive an option’s price is to various factors.
The added complexity of options does bring several benefits, however. There are a vast number of trading strategies to help you find opportunity in any market conditions or to trade on volatility itself. When buying, you can also benefit from higher degrees of leverage while capping risk to your initial outlay.
With IG, you can trade CFDs across a huge range of markets – including options. Open a live account to get started.
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