CFDs vs Futures: which one to trade?

CFDs vs Futures: which one to trade?
CFDs vs Futures: which one to trade?

Financial markets have traditionally involved parties buying and selling securities, commodities, and other market tradeable assets. However, modern finance has evolved to include trades in financial instruments that derive value from the assets. These financial instruments go by the name derivatives.

Traders use derivatives for two primary purposes: to hedge against risk and to generate profits. Under the derivatives umbrella, one finds futures and forwards, options, contracts for differences (CFDs)and swaps. For starters, these assets derive their value from underlying assets but significant differences exist among them. This article explores the differences between CFDs and futures.

 

CFDs vs. Futures Comparison Table

 

CFDs Futures Contract
Settlement of Contract Contracts are strictly settled in cash Contracts could be settled in cash, or buyers can take (or sellers can supply) physical delivery of the underlying asset.
Purpose of Trading Mostly, traders enter contracts for the sake of profit-making Traders buy/sell futures contracts to hedge against wild price swings in the future or speculate for the profit-making purposes
Asset Types Traded on all types of market-traded assets A large portion of the futures market involves commodities
Leverage Traders can leverage their positions to amplify gains Similarly, leveraged trades are allowed in futures trading
Long / Short Trading Traders can take long or short positions Traders can take long or short positions
Termination The contract can terminate at any time as the trader wishes The contract terminates only at the fulfillment date.
Pricing Do not have a set price. Instead, contracts are settled at the spot price Contracts have preset prices (strike price)

 

What are the main differences between CFDs and Futures?

 

1. Termination of contract

As the name suggests, the contract for differences is a contract in which one enters intending to profit from the difference between the contract opening and closing price. Say, Greg comes a contract to buy British Pound (GBP)using the US dollars (USD). Assume the price at contract opening was GBP/USD 1.25. If the GBP/USD exchange rate increases to 1.26, the difference between the two prices is Greg’s profit. Greg can decide to exit the contract at any point he deems appropriate.

If Greg were to enter a futures contract for the same currencies, the transaction would be different. In the first place, Greg has to agree with the seller the price at which he would buy the GBP at a specific date, say after seven days. When the seven days arrive, and GBP’s price is higher than the agreed sum, the difference equals to profit for Greg.

How future contract works

From the above, it is clear that CFDs do not have strict deadlines. Greg can enter a trade any time as long as his analysis concludes the condition is preferable. Afterward, Greg can exit the contract when it is appropriate. On the other hand, Greg’s futures contract cannot terminate until the time comes. The only option available is to sell the contract in a secondary market i.e., on an exchange.

 

2. Settlement of the contract

In both cases, parties are entering a contract either to sell or to buy an underlying asset. But a CFD is far more different from the underlying asset. For instance, say Greg decides to buy a CFD for Amazon stock. Typically, an investor who buys a company’s share has a partial claim to the profits and losses made. Contrarily, a CFD does not confer such a claim to the buyer or seller. Instead, one uses the CFD to speculate on the price of the stock. Besides, the CFD allows Greg to benefit whether the stock price declines or rises. For this reason, the settlement of CFD is strictly cash-based. After all, the CFD merely mimics the underlying asset.

A future is different. For example, if Greg enters a contract to buy 100 shares of Amazon in 90 days at $100 per share, he can accept the physical delivery of the shares or cash. It is because a future is a contract that involves conferring one a claim to the underlying asset. After 90 days, the seller will require Greg to hand over $10,000 in exchange for the shares.

 

3. How to enter contracts

CFDs are flexible, easy to trade, liquid, and less regulated. To open a CFD trade, one needs to open an account with a broker. Thousands of brokers across the world (except the US) offer opportunities to trade CFDs. Trading CFDs is flexible because it does not involve an exchange. It implies that the regulation of CFDs trading is less strict.

On the other hand, the market for futures contracts is on exchanges. One has to sign on a platform like the Chicago Mercantile Exchange (CME) to enter a futures contract. It also means that guidelines are stricter. For example, an exchange cannot allow overleveraged trades, as it is a norm for CFDs trading. Some of the leverage implemented for CFDs is eye-popping when viewed from the futures trading lens.

 

CFDs and Futures, Which One Should I Choose?

From the perspective of liquidity and flexibility, CFDs are the best choice. One can exit the contract whenever appropriate. Hence, one can take advantage of as many profitable trading opportunities as possible. However, excess leverage makes CFDs highly risky. Also, dishonest brokers can make traders’ lives a nightmare. (Understand more about the risk management in CFD trading.)

On the contrary, futures come on top in terms of risk management and transparency. The leverage employed here is low, which means the amplification of losses (and gains) is reasonable. However, the inability to exit the contract quickly makes futures a risky play when the market moves against you.

 

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Risk Warning: The above content is for reference only and does not represent ZFX’s position. ZFX does not assume any form of loss caused by any trading operations conducted in accordance with this article. Please be firm in your thinking and do the corresponding risk control.

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