If you are wobbling your head about the difference between CFDs and futures, you are not alone.
Many traders come across CFDs and futures when they start trading. Most people, however, do not know the differences between them.
In this guide, we'll tell you what CFDs and futures are, how you trade them and what the difference between the two is.
What are CFDs?
CFDs are a type of leveraged financial derivative that allows you to speculate on the price movement of an underlying market without taking direct ownership. For example, if you believe the price will climb, you would 'buy the underlying market. On the other hand, if you believe the price will decrease, you would 'sell' the underlying market.
When trading CFDs, your profit or loss is determined by multiplying your entire position size by the difference between your positions open and closing prices.
How do CFDs work?
You do not own the underlying asset when you acquire a CFD contract; rather, you speculate on its price fluctuation. You can also trade CFDs on leverage, which means traders only need to stake a modest amount (margin) to manage a much greater market position.
For example, if a broker offers 100:1 leverage, a $1,000 margin is required to manage a $100,000 trade position in the market.
Leverage helps you to spread your capital and earn more returns with a smaller investment. However, leverage is a double-edged sword, and huge losses can be incurred on transactions that go against your expectation. Therefore, a CFD price reflects both bids and offers.
Buyers bid for the price they are willing to pay, while sellers ask for the lowest amount they are willing to accept. A CFD's spread is the difference between the bid and ask prices, which gives us a sense of how much it costs to trade.
You can be charged extra fees in addition to spreads if they leave open trades overnight. It is called a rollover fee or switch fee. A broker charges this for keeping a leveraged position in the market outside of busy daily trading hours.
It's effectively a charge for overnight funding. There are no additional hidden fees or charges on the forex broker platforms, thus spreads and rollovers are the only CFD trading costs.
What can you trade with CFDs?
You can trade forex pairs, stocks, commodities, energies, cryptocurrencies, ETFs, and bonds.
To trade CFDs, first, you need to select the asset you want to trade, like forex pairs, commodities, or cryptocurrencies. After that, you must select if your chosen market will move in a bullish or bearish direction.
Traders make judgments based on various facts. For example, fundamental analysts look at facts and numbers, but technical traders just look at price charts.
On your trading platform, you see both a buy and a selling price. So if you feel your asset is going up, buy it; if you believe it is going down, sell it.
The value of your transaction, as well as how much you gain or lose for each point of change in the underlying market, is determined by the number of CFDs you purchase or sell.
Depending on the asset you're trading, the value of a single CFD fluctuates. In the case of equities, a CFD is the same as buying or selling a single share. It's the same as a single lot in forex trading. For various assets, your CFD may be priced in multiple currencies.
Remember that CFDs are leveraged, which means you won't have to put up the entire amount of your trade upfront.
You'll be able to view any active gains or losses on the open positions section of your trading platform after opening the trade. The price changes of the underlying market will be reflected in the value of your position as it rises and falls.
You'll close your trades by trading in the opposite direction. For example, to net off your exposure, if you sold 10 CFDs at the start, you'll need to acquire 10 CFDs today. If the market price reaches your stop or take profit level, your trade will be immediately closed.
Pros of CFDs
● You do not gain any rights or responsibilities about the underlying asset, and you do not own it.
● When compared to owning the underlying asset through leverage, opening a trade requires much less capital.
● Short or long bets can be initiated based on the current market conditions and trading strategy.
● From the same platform, you can trade multiple assets.
Cons of CFDs
● You can't benefit from small moves since you have to pay the spread on entry and exits.
● CFD trading is a lightning-fast market that demands constant attention. You blink, you sneeze, and gone are your opportunities.
What are futures?
A futures contract involves two parties agreeing to trade an underlying market later for a predefined price.
When a buyer or a seller enters into a futures contract, the buyer accepts the responsibility to purchase the underlying market at or before the contract's expiration for the preset price. Likewise, a seller accepts the right to sell it at the contract's expiration or before it.
How do futures work?
Futures are commonly used to hedge against underlying market price rises. Futures contracts allow you to lock in a price and protect yourself from significant price fluctuations (up or down) in the future.
To get an idea of how futures work, consider an example:
An airline business that wants to avoid an unexpected spike in jet fuel prices can acquire a futures contract that commits them to buy a certain volume of jet fuel for delivery at a certain price in the future.
A fuel distributor could sell a futures contract to ensure a continuous fuel supply and protect itself against a price drop.
Both parties agree to precise conditions for the purchase or sale of 1 million gallons of fuel, with delivery in 120 days and a $5 per gallon price.
Both parties, in this case, are hedgers or genuine firms that must trade the underlying commodity because it is essential to their operations. Therefore, they utilize the futures market to limit their risk of price fluctuations.
However, there's a twist! Not everyone in the futures market wants to trade on futures. Instead, these individuals are futures investors or speculators who aim to profit from fluctuations in the contract's price.
If the price of jet fuel jumps, the value of the futures contract climbs too, and the contract owner may be able to sell it for a higher price in the futures market.
These investors can purchase and sell futures contracts without intending to deliver the underlying commodity; instead, they're in the market to speculate on price changes.
What can you trade with futures?
You can trade forex pairs, stocks, commodities, energies, cryptocurrencies, ETFs, and bonds. Futures contracts are often traded on an exchange, with one side agreeing to buy a specific number of securities or commodities and accept delivery on a specific date. The contract's selling party commits to supply it.
The futures exchange where the contract is traded will determine whether the deal is for the actual delivery or paid in cash. For example, a company may enter into an actual delivery contract to seal in or hedge the price of a commodity that it requires for manufacturing.
The majority of futures contracts, on the other hand, come from traders who are speculating on the market. Thus, the difference between the original deal and the closing trade price is closed out or netted in these contracts.
A futures contract allows you to bet on how a commodity's price will change in the future. For example, they would profit if they bought a futures contract and the asset's price climbed and was trading higher than the original contract price at expiry.
Before expiration, the long position would be effectively closed by offsetting or unwinding the buy trade with a sell trade for the same price at the current value.
The difference in price between the two contracts would be paid in cash in your brokerage account, and no actual goods would be exchanged. However, you can lose if the asset's price was lower than the buying price indicated in the futures contract.
If you believe the underlying asset price will decline, you can take a speculative short or sell position. If the price falls, you will close the contract by accepting an offsetting position. The contract's net difference would be paid at the contract's end.
Trading futures as a hedge
Futures can be used to protect against price fluctuations in the underlying asset. Rather than speculating, the objective here is to protect losses from any negative price movements. Many hedge fund businesses use—or, in some circumstances, produce—the underlying asset.
Corn producers, for example, can apply futures to lock in a price for selling their product. Thus, they decrease their risk and ensure that they will obtain the agreed-upon price. In addition, hedging corn would compensate the farmer for losses from selling grain at the market if corn fell.
Pros of futures
● An underlying asset can be speculated on using futures contracts.
● The cost of raw materials or goods can be hedged so that companies are protected from price fluctuations.
● Futures contracts only need a fraction of the contract's value to be accumulated with a broker.
Cons
● Because futures employ leverage, you run the danger of their losing more than the initial margin amount.
● A hedged firm may lose out on positive price changes if it invests in a futures contract.
Now that you understand what CFDs and futures are, let's tell you the differences between the two.
1. Standardization
To begin, the two forms of derivatives differ in terms of where they are exchanged. Futures contracts are exchanged on regulated exchanges like the NASDAQ Futures Exchange (NFX), Euronext, etc. Ultimately, this standardization makes future products highly standardized and precise. The only difference between contracts is the settlement date.
Contracts for difference, on the other hand, are over-the-counter (OTC) products. They are not offered by formal exchanges but rather by brokers who set their own conditions. CFD providers establish and broadcast real-time pricing as well as construct a market for assets to trade.
2. Spread
The difference between the price of purchase and the sale of an asset is called the spread. Spreads are used for trading both futures and CFDs. Conversely, spreads on futures are fairly modest. On the other hand, CFD providers frequently use the futures market to hedge their holdings, so CFDs have a wider spread than futures.
3. Contract size
Futures are meant to be used by major investment institutions and are exchanged on large exchanges. As a result, such contracts frequently have significant minimum quantities. One crude oil futures contract on the COMEX, for example, has a minimum unit of 1,000 barrels. Contracts for difference are significantly more flexible in this regard, and they are offered to small traders who cannot afford a bigger exposure.
4. Leverage
Leverage allows you to gain exposure to larger trades with a smaller initial investment. This original deposit is multiplied or leveraged, and profit or loss is calculated depending on the entire amount. Futures leverage differs from contract to contract, although it is not particularly adjustable in general. A clearinghouse or exchange determines the starting margin (the minimum deposit necessary to acquire a futures contract) for each futures type. Most futures contracts require an initial margin of about 5-10%.
A CFD trader's counterparty is a broker, not an exchange. CFD contracts are provided by a broker, who has the authority to determine the initial margin value. This implies that they have alternatives to pick up to the broker's maximum limit for individual traders.
5. Expiration date
Contracts in the futures market always indicate the dates on which they will expire. This is the deadline for the underlying asset that you have to deliver at the agreed-upon price under the contract conditions. The exchange that supplies the market sets the expiration dates for each futures contract. In reality, most futures contracts are settled before they reach their expiration date. Traders who do not intend to take delivery to enter into futures contracts. They are just interested in profiting from market price swings.
In contrast, a contract for difference does not have an expiration date or a price for the future. When the underlying asset's price falls against you, you engage in a contract and liquidate it. The profit or loss at the end of the contract is the difference between its start and end prices.
How to manage risk when trading CFDs and futures?
Risks have to be managed regardless of whether you are trading CFDs or futures. Unfortunately, traders often get carried away when speculating on the financial markets. They enter at the wrong time and don't pay heed to market analysis. This is the reason why many traders fail. However, you can manage risks by following a few steps.
Have a trading plan
One of the key aspects of risk and money management is discipline. Many investors don't hesitate to start a trade, but they don't always know what to do next or when to do it. Having a strategy in place will keep you disciplined and prevent you from succumbing to emotions like fear and greed, which will lead to failure.
Risk/reward ratio
So, how much should you risk on a trade? There is no hard and fast rule here, but account size, risk tolerance, financial goals, and how it fits into the overall trading plan should all be considered. Generally, the risk/reward ratio is 1:2. This means for every dollar lost, you have to earn 2 dollars per trade.
Place a stop-loss
You shouldn't underestimate the value of a stop-loss order in risk management. You'll be more diligent in your money management if you set stop-loss orders. The most important thing to remember when putting your stops in place is that the stop price must be appropriate for the market. If the necessary risk on a transaction is too high for your risk tolerance or account size, you should look for another market.
Final thoughts
Although they have almost identical underlying assets, futures need a large minimum commitment, whereas CFDs do not have this requirement. CFDs appear to be a more suitable option due to the efficiency this trading type offers to retail traders, despite these being high-risk products. With the flexibility this type of trading offers individual traders, CFDs may be a more appealing trading option with new trading strategies. However, remember that having adequate risk management methods and market expertise is critical to long-term success, regardless of what you're trading.
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