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Below is a contributions from BoomBustBlogger Michael Holland. As I have received several inquiries into trading practices from the less experienced on this site, I thought the following piece may be of interest to some. Mr.  Holland's only affiliation to BoomBustBlog is that of a reader and follower. With that in mind, please read on....

CFD trading and options trading compared

CFDs and options trading are two of the most popular financial derivatives and although there are many similarities between them, there are also vital differences.

Derivates and leveraged

Both are derivatives, i.e. their values are derived from the value of some underlying asset – whether this be a share, commodity or currency. Both are also leveraged investment instruments, which means the trader can control a much larger amount of money than he or she has available to trade with.

Premiums

An option provides its owners with the opportunity, but not the obligation, to buy the underlying asset at the strike price (an agreed price) on a specific future date (the expiration date). To acquire a call or put option a trader has to pay an options premium – which will be forfeited if the underlying asset fails to reach the strike price on the expiration date.  

A CFD on the other hand is a more direct investment in the underlying asset. It has no expiry date and unlike with call or put options there is no costs involved accept for the CFD spread and finance charges on the open (long) position.

Profit/loss comparison

Take for example the shares of company ABC, currently trading at $100 per share. A trader who believes that these shares will gain in value over the next 3 months could either buy CFDs on e.g. 100 shares or buy 1 contract of call options representing 100 shares. The risk/reward profiles of the two trades are set out below in Fig. 10.29(a) and 10.29(b).

What immediately becomes clear is that:

1. The CFD position has unlimited risk to the downside. With the options position on the other hand, the maximum risk is limited to the amount that was paid for the options.
2. If the price of ABC shares remains completely stagnant, the CFD trader will only incur a small cost (the CFD spread and possibly finance charges), while the options trader would lose the premiums he/she paid for the options at the start of the trade.
3. The maximum profit of the CFD trade for a given price increase in ABC shares is somewhat higher than that of the call options. This is a direct result of the options trader having had to pay a premium for his or her options.
4. The options position only becomes profitable if the underlying asset increases with an amount that exceeds the premium. In this case the breakeven point is just over $104. The CFD position starts to make a profit as soon as the (relatively small) spread has been recovered.

Anyone who is 100% sure that the price of the underlying asset is going to increase would therefore be better off choosing the CFD trade. Unfortunately traders very seldom operate in a world where anything is 100% certain. If there is any significant risk of a price decline, the trader would therefore be better off buying call options, because in that case the downward risk is limited to the options premium.

It also has to be said that options are very flexible trading assets. A trader can benefit from both price increases (call options) and price decrease (put options) and these can be combined in innovative ways to create unique risk profiles which are simply not possible with CFDs alone.

Options trades can also be used to hedge CFD trades. More about that in a later discussion.

Marcus Holland is editor of the website - FinancialTrading.com.