- Education
- Trading CFDs
- CFDs vs Futures - Difference Between CFD and Futures
CFDs vs Futures - Difference Between CFD and Futures
If you're new to trading, you may find CFD trading and futures confusingly similar. Both are derivatives that offer leverage benefits, but that's where the similarities end. In fact, there are cases where one may be more suitable than the other.
Futures are typically traded on exchanges, while CFDs are more commonly traded directly with brokers. The biggest differences between the two lie in liquidity and financing. CFD orders are more readily filled, making them a more practical choice for many traders. Plus, they typically have lower barriers to entry than futures contracts.
If you're looking to dip your toe into the world of trading, CFDs may be a great place to start. They offer flexibility, accessibility, and can help you build your trading skills. On the other hand, if you're looking for more advanced trading opportunities, futures may be the way to go.
Whatever your trading goals may be, make sure you do your research and choose the instrument that's right for you. With the right approach, both CFDs and futures can be powerful tools for building your trading portfolio.
KEY TAKEAWAYS
- CFDs and futures are confusingly similar. Both are derivatives that offer leverage benefits, but that's where the similarities end.
- A CFD is a type of contract where two parties, namely a buyer and a seller, come to an agreement. The deal works by having the seller pay the buyer the positive difference between the opening and closing prices of a specific financial instrument, while the buyer pays the seller the negative difference.
- A futures contract is an agreement between two market participants to buy or sell a financial asset in the future at a pre-agreed price.
Difference Between CFD and Futures
If you are new to the world of trading, the differences between CFDs and futures might be confusing for you?
Both of these instruments offer exciting opportunities to make leveraged trades, but they operate in slightly different ways.Whether you're a seasoned trader looking to explore new instruments or a beginner trying to figure out the basics, this guide will help you understand the ins and outs of CFDs and futures trading. So, let's dive in!
| Futures | CFDs | |
|---|---|---|
| Trading Platform | Exchange | Over-the-counter (OTC) |
| Guarantor | Exchange | Financial Company (e.g. broker) |
| Price Determination | Exchange Trading | Broker-set Price Equal to or Close to Exchange Price |
| Trading Costs | Exchange Spread and Broker Commission | Broker-set Spreads |
| Capital requirement | Higher | Lower |
| Leverage | Lower | Higher |
IFC Markets offers the opportunity to download MetaTrader 4, the leading trading platform, so you can trade CFDs and Futures across global markets with ease.
What are CFDs
So what is CFD trading?
A CFD is a type of contract where two parties, namely a buyer and a seller, come to an agreement. The deal works by having the seller pay the buyer the positive difference between the opening and closing prices of a specific financial instrument, while the buyer pays the seller the negative difference. Additionally, the contract sets out the time when this difference is calculated.
CFD Example
It's easier to understand what CFD is by giving an example. Let's say a trader bought 1 CFD for mini Dow Jones at 5,400 points and sold this contract at a price of 5,700 points. Thus, the difference between the opening and closing of the index was 300 points. The trader's profit, with the cost of one contract being $5, was $5 * 300 = $1,500. If the index had not risen, but had fallen by 300 points, the trader would have lost $1,500 on this deal.
At first glance, CFD trading may not seem much different from trading currency pairs. Although CFD is a mechanism for trading a base asset, the asset itself underlying the CFD is not involved in the trading. This allows the trader to not work in the financial instrument market but to achieve the same financial result.
The Essence of CFD
CFDs were invented by English brokers who decided to interest clients in trading stocks without paying a special tax. Formally, the conclusion of a CFD transaction was not considered a transaction with a stock and was not subject to tax. Later, CFD became an ideal tool for those who did not have the opportunity to enter the market, for example, due to a lack of funds.
What are Futures
A futures contract is an agreement between two investors:
- The seller of the futures contract agrees to sell the underlying asset specified in the contract to the owner of the futures contract on a specific date (this underlying asset is called the "underlying").
- The buyer of the futures contract agrees to purchase the underlying asset from the seller on a specific date.
Neither the seller nor the buyer of the futures contract sign any documents with each other. To participate in the transaction, it is sufficient to simply buy or sell the futures contract through a broker's application.
Another important feature is that the seller of the futures contract does not actually transfer the underlying asset to the buyer. Instead, money is credited and debited from their accounts on a daily basis in accordance with the change in the market price of the futures contract.
The underlying asset of a futures contract can be securities, indices, currency, commodities, and much more. The price of the futures contract may be higher, lower, or equal to the current price of the underlying asset. This depends on what investors expect from the underlying asset in the future: growth or decline.
Futures Example
Suppose that X company is a manufacturer of widgets, and you are interested in trading futures contracts based on the price of X company's widgets. You believe that the price of X company's widgets will increase in the future, and you decide to buy a futures contract at a price of $50 per widget.
Each futures contract is for 1,000 widgets, so the total cost of the contract is $50,000 (i.e., 1,000 widgets x $50 per widget). The contract specifies that the delivery of the widgets will be made in three months.
Now suppose that the price of X company's widgets actually increases to $60 per widget three months later. At this point, you decide to sell the futures contract to another trader at the current price of $60 per widget. You receive the difference between the initial price of $50 per widget and the current price of $60 per widget, which is $10 per widget.
Since each futures contract is for 1,000 widgets, you receive a total of $10,000 (i.e., $10 per widget x 1,000 widgets) from the buyer of the futures contract. This represents your profit from the futures trade.
However, it's important to note that futures trading also involves risks, and the price of X company's widgets could also decrease instead of increasing, resulting in a loss for the trader.
Futures Trading Risks
When trading futures, it is important to remember that in some cases the potential losses can be unlimited.
The risk of leveraged trading is that you do not need to pay the full price of a futures contract to purchase it. You only need to have enough funds in your account as collateral or liquid assets to open a position. The collateral amount is not deducted from your account, but only blocked on it while you own the futures contract. Typically, the collateral is only 10-40% of the contract price.
On the one hand, this allows you to buy a futures position that significantly exceeds the amount of money you actually have in your account. And if your trading strategy proves successful, this can bring you additional profits.
On the other hand, in case of failure, you risk losing several times more money than you have. And the size of such losses is unlimited.
For example, if you have $10,000 in your account, this is enough to provide collateral for a futures contract worth $100,000, which is 10 times more than the actual amount of money you have.
A few days later, the price of the futures contract increased by 10%, and thanks to the leverage effect, you made $10,000. If you traded only with your own money, the income would have been only $1,000.
But if the price of the futures contract falls by 10%, your loss will be the same $10,000, which will be debited as a variation margin on the same day. To continue holding the futures contract, you will need to replenish your account with the amount of collateral, otherwise your position may be closed forcibly - this is called a "margin call."
The higher the leverage, the more money you will need to deposit into your account to continue holding the futures contract. As a result, your losses can be multiple times more than your initial investment.
Inability to "wait out" losses - owning futures differs from owning regular stocks. If the price of a stock falls, you can do nothing and just wait for it to rise again. The financial result when trading stocks - that is, profit or loss - occurs only at the moment of sale.
The financial result of a futures contract is calculated every day and immediately credited or debited from your account, respectively, increasing or decreasing the amount of money you have.
Risk rate changes - when there are sharp changes in the market, the exchange may increase the size of collateral for futures contracts. If the investor does not have enough funds in the account to cover the collateral, the broker may forcibly close any liquid position in their portfolio to return the necessary level of money to the account - this is called a "margin call".
For example, let's say you have $10,000 in your account. You bought a WTI crude oil futures contract for $60,000 with a 15% risk deposit, meaning you reserved $9,000 on your account to secure your futures position.
Suddenly, the price of oil changes sharply and the exchange raises the risk deposit for this futures contract to 40%, meaning you now need to have $24,000 in your account. If you don't add more money to your account or sell the futures contract in the near future, the broker will forcibly close your position.
The Essence of Futures Trading
A futures contract is an agreement between two market participants to buy or sell a financial asset in the future at a pre-agreed price. Often, these contracts are closed out before their expiration date without any actual delivery. Trading in futures is considered more risky and speculative due to its complexity and lower margin requirement compared to trading in stocks. Some believe that futures are a tool more suitable for short-term traders than long-term investors.
Benefits of CFD Trading
With so many CFD brokers out there, it can be hard to separate truth from fiction when they tout their long lists of advantages. But fear not, we'll start by giving an unbiased overview of the benefits of trading CFDs, before diving into their risks and downsides.
CFD contracts are a big deal in trading, and for good reason. In this section, we'll explore the advantages of trading with CFDs.
CFD trading has become a popular choice for investors due to its many benefits. One of the biggest advantages is the ability to use leverage, which allows you to trade with a small deposit and still have access to a large portion of the market. Professional traders can access leverage up to 1:500, while retail traders can access up to 1:30.
Example
Leverage: Let's say you have $1,000 in your CFD trading account and want to trade on a market that offers a leverage of 1:30. With this leverage, you can now open positions worth up to $30,000 ($1,000 x 30) even though you only have $1,000 in your account.
This means that if the market moves in your favor, you can potentially make a profit based on the entire $30,000 position, rather than just your initial $1,000 investment. However, keep in mind that the same leverage that magnifies your potential profits also magnifies your potential losses, so it's important to use leverage responsibly and manage your risk.
Another benefit of CFD trading is the ability to profit from both rising and falling markets. You can buy or sell assets, giving you more flexibility and the potential for higher profits. Additionally, CFDs are available for a wide range of markets, including currencies, stocks, bonds, indices, commodities, and ETFs.
Example
Markets available: With CFDs, you have access to a wide range of markets to trade on, including major currencies, stocks, bonds, indices, commodities, and ETFs. For example, you could trade CFDs on popular indices like the S&P 500, Dow Jones Industrial Average, or NASDAQ, as well as on individual stocks like Apple, Microsoft, or Amazon.
CFDs are also useful for short-term trading, allowing you to take advantage of short-term price fluctuations without a large initial investment. And unlike some other types of derivatives, such as futures contracts, CFDs generally do not have an expiration date.
This means that you can hold a CFD position open for as long as you like, provided you have enough margin in your account to cover any potential losses. However, keep in mind that holding a position open for an extended period of time may incur overnight financing fees, which can eat into your profits.
Example
Short-term trading: CFDs can be used for short-term trading strategies, such as scalping, which involve opening and closing positions within a very short time frame (often just a few minutes or seconds).
For example, you might use technical analysis to identify short-term price trends in a particular market and enter and exit trades accordingly. However, keep in mind that short-term trading can be risky and requires a high level of skill and discipline.
Trading costs for CFDs are often lower than other forms of investment, with no commissions for opening or closing a trade. Instead, brokers earn income from the spread, which is the difference between the buy and sell prices. While there may be taxes and fees involved, these depend on location and usage, and it's best to consult with a tax professional for more details.
Example
Trading costs: One of the advantages of CFD trading is that it generally involves lower costs than other forms of trading. For example, instead of paying the full value of an asset, you only need to put up a small margin deposit to open a CFD position.
In addition, most CFD brokers charge only a small spread (i.e., the difference between the buy and sell prices of an asset) as their main source of revenue, rather than commissions or other fees. However, keep in mind that some brokers may charge additional fees for certain services, such as withdrawing funds from your account, or for holding positions open overnight.
Overall, CFD trading offers many benefits and can be a great option for investors looking for flexibility, lower costs, and the potential for higher profits.
Benefits of Futures Trading
Not sure about the benefits of Futures Trading? Well, let us tell you, there are plenty of advantages to trading futures!
First off, one of the biggest benefits is leverage. This means that you can pay a margin and get the same benefit of buying the entire quantity of stock.
For instance, let's say you want to invest in Infosys, and buying 600 shares at the current price would cost you nearly Rs. 900,000. Instead, you can buy one lot of Infosys futures with a margin of Rs. 180,000. By doing so, you are paying for 120 shares but getting virtual participation in 600 shares, which means your profits can potentially be 5 times better.
Another advantage of futures trading is that it's agnostic to market direction. If you are positive about a stock, you can buy it, and if you have a negative view, then just sell futures. This allows you to be flexible with your trading strategy regardless of the market's direction.
Futures also allow you to take a consolidated view of markets or sectors. For example, let's say you're bullish on the banking sector due to a likely rate cut by the FED. Instead of selecting individual banking stocks, you can just buy the Bank S&P 500 Futures. This way, you get all the benefits that banks will get from a rate cut without exposing yourself to stock-specific risks.
Futures contracts can also help limit downside risk in stock positions. For instance, you might expect the market to correct by 10-12% due to macro concerns. However, you believe that the correction would be temporary and markets would bounce back. In such a scenario, you can hold on to your stocks and sell S&P 500 futures against them. When the market corrects, you can sell the futures and the profits will help you reduce the cost of holding your cash market position.
Moreover, there is no risk of default in trading futures. When you buy and another person sells, there's always a risk that one of you could default. However, on the stock exchange, the clearing corporation gives a counter-guarantee for every futures trade in the stock market. This ensures that even if one party defaults, the exchange makes good the loss through the clearing corporation, eliminating single-party default risk and allowing you to trade with confidence.
Index futures can also help diversify your portfolio.
Let's say you have a portfolio predominantly biased in favor of financial stocks, but you see the risk of FED hiking rates. You believe that non-cyclical sectors like pharma, and IT would not be perturbed and would benefit instead. Instead of making your portfolio heavier by buying these stocks, you can simply buy futures on IT and automatically de-risk your portfolio.
Lastly, remember that it's cheaper to trade futures! The commission rates and STT rates on index futures are much lower compared to equities or even stock futures. Most brokers today offer fixed brokerage packages on indices, making it a lot more economical.
So there you have it! These are just a few of the many benefits of futures trading. Don't hesitate to explore this exciting opportunity and see how it can benefit your portfolio.
Bottom Line on CFDs vs Futures
In conclusion, while CFDs and futures may seem similar on the surface, there are important differences to keep in mind. CFDs offer flexibility and the ability to trade on a wide range of markets, while futures allow traders to bet on the value of an underlying asset at a specific point in the future.
Ultimately, the choice between CFDs and futures depends on your individual trading goals and preferences. So take the time to do your research, analyze the market trends, and make informed decisions. And always remember to trade responsibly and never invest more than you can afford to lose. With these tips in mind, you'll be well on your way to success in the exciting world of trading.
