CFDs vs. Options: 6 Major Differences

Newcomers in the trading space have flocked to many different types of financial assets, though financial derivatives like CFDs (contracts for difference) and options are the most popular ones.

Financial derivatives like these are assets that "derive" their price from a real asset, mimicking its price movement on a real chart. However, unlike "real" assets, derivatives like CFDs and options don't have to be physically owned to make a potential profit, making them attractive to newcomers.

Key Definitions

CFD Trading

CFD trading is a financial derivative that enables investors to speculate on the future price of an asset without actually owning it.

As opposed to buying/selling a physical asset, CFDs allow traders to trade in real-time and gain exposure to both rising and falling markets. This is because CFDs allow traders to open both long and short positions without requiring them to file the necessary paperwork behind every position.

However, it's important to keep in mind that a CFD position will charge you an overnight fee for every night the position remains open. Although this fee is small, the amount can reduce your profits if you hold your position for too long.

Let's take a look at an example of a CFD trade. You deposit $400 in your trading account and you're ready to open your first position with a stock like Microsft (MSFT). You believe that due to a new product they offer, the share prices will increase, so you'd like to open a long position with 2 shares, predicting the price will go up. The price per share is currently at $200, but with 1:10 leverage, you can buy 20 shares instead of 2. After the price of the stock increases by 2% at $204, you close the position with a 40%, calculated with the following formula:

In your case, this translates to:

2 x 2 x 10 = 40% - (fees you'll incur)

Options Trading

Options trading is a type of financial derivative that allows the buyer to purchase an option, giving them the right (but not the obligation) to buy or sell a security at a specific price at or before a given date. Options have the factor of time and price, while CFDs don't.

There are two types of options contracts:

• Call options: grant the buyer the right to buy
• Put options: Grant the buyer the right to sell

At first glance, options might seem a lot more complex than CFDs, but a brief example will quickly get you to understand. Let's take the MSFT stock as an example again, where you invest $400 to buy two contracts worth 10 shares, allowing you to control $2,000 worth of shares with only $400 (similarly to leverage in CFDs). When creating your contract, you specify the expiration date on the 1st of February with a price prediction of at least $204. So, when the date comes, your position gets closed, and the profit is calculated:

Meaning:

• 2 x 10 x 2 = 40% (minus the fees, which are smaller than with CFDs).

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Main Differences Between CFDs & Options

1. Ownership Possibility

While both of these financial instruments are derivatives (meaning that they artificially "derive" their price from an asset), ownership with options contracts is possible.

Traders can exercise their ownership rights under a call option contract to acquire ownership of the underlying asset, not just speculate on the derivative.

This isn't the case with CFDs, which are purely speculative and cannot be owned by the trader.

2. Trading Costs

Options have a much lower trading fee than CFDs. This is because CFDs have a higher spread and an overnight fee, a fixed rate the trader is charged for every night the position is left open.

Options have no overnight fee and a much smaller spread, making them more cost-effective for traders.

3. Financing Costs

As CFDs are leveraged instruments, they require traders to deposit a percentage of their position (margin) with their brokerage and in turn, pay interest on whatever amount is left unpaid.

Options do not have this extra cost as they are not leveraged instruments by default.

4. Complexity

Options are generally viewed as much more complex than CFDs since they come with specific details like an expiration date, price targets, as well as the option of exercising ownership rights. This means that traders have to be aware of the contract's specific details in order to make a potential profit from their position.

CFDs, on the other hand, involve no special conditions and can be held for any period of time.

5. Risks of Loss

With options, traders are exposed to time-based risk, meaning that if an option has not expired in the trader's favor, they will lose money.

CFDs pose a risk of margin calls—you can choose to deposit additional funds or close positions, when your position is too close to the margin.

So, we can rate them as equally risky, but the risks with CFDs can be more easily mitigated.

6. Transparency

As an instrument, options tend to be more transparent than CFDs as they clearly specify the expiration date and price mark. This makes it easier for traders to determine how the option will be closed.

With CFDs, there can be a lot of ambiguity surrounding the terms of closing a position.

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So, Which Is Better?

CFDs offer the flexibility to trade in any timeframe and at any price mark, while options provide a more transparent trading experience that comes with the possibility of ownership rights.

It all depends on the preferences of the trader, so it's important to weigh up the pros and cons of each instrument before deciding which is best for you.