CFDs vs Futures | Differences Explained

There is some overlap between CFDs vs Futures - this is a guide explaining the difference and when one might be better to use than the other.

Contents: CFDS vs futures


Introduction to CFDs and Futures
Key Differences Between CFDs And Futures
Why Do Traders Use CFDs?
Why Do Traders Use Futures?
Conclusion

Introduction to CFDs and Futures

CFDs and Futures are used by different types of investors. Outside of individual equities, they are two of the most popular ways to trade indices, currencies and commodities, representing some of the biggest markets in the world. Both types of financial instruments are easily accessible with online trading platforms, making them extremely popular and some of the most widely used financial tools.

CFDs Explained

CFD stands for Contract For Difference, when you enter a CFD trade, you do not buy the actual asset, you make an agreement with the broker, and within that agreement, you make a bet on where the future price will go.

You can bet long (that the price will increase) or Short (the price will decrease) and if you are right the broker will pay you the difference between the price of the asset from when you entered the contract to when you closed (sold).

If you are wrong and the price goes in the opposite direction to the way you thought, you will have to pay the broker the difference out of your account balance.

Futures Explained

A Futures contract is an agreement that you enter with a broker to buy or sell an asset at a set future price. Futures contracts allow traders to bet on the direction of a security, stock index, commodity, or other financial instruments, either long or short.

Futures are frequently used in professional environments as a hedge for the price movement of an asset to help offset the risk of loss over short periods of time from unfavourable price changes.

Both of these instruments are derivatives, this means that you do not buy the underlying (Physical) asset that you enter the contracts for. This means that you can bet on the price for a huge quantity of an asset, for example, the value of 20,000 bushels of wheat, without needing to buy or store the physical agricultural commodity.

Key Differences Between CFDs And Futures

There are three main differences between futures and CFDs which determine who uses them and the best instrument to use at different times.

Spreads

Spread is the difference between the buy and sell value of an asset. In times of high market volume spreads will decrease, and when there is low volume in the market spreads will increase. When trading CFDs, traders will typically only pay a spread, whereas with futures there is a spread charged by the futures exchange plus a commission charged by the broker.

Holding Period

CFDs are meant to be short term contracts, they most cost efficient for holding periods under one year. This is because they incur overnight fees known as ‘financing costs’, meaning that, the longer you hold the trade, the more expensive it will get. Futures do not incur overnight fees because any effect from interest rates is built directly into the futures prices relative to when it expires. It is common for futures traders to hold their positions for several weeks but the contracts will expire and need to be rolled into the next contract period.

Expiration

CFDs do not expire because the trade is being continuously rolled over - hence the overnight fees. THe benefit is that you can maintain your open trade without any need to close a position and roll it into the next contract. Futures, on the other hand, do have an expiry date set by the futures exchange when the contract is formed.


Why Do Traders Use CFDs?

CFDs are regularly used by retail investors. These are everyday people who use their own money to invest in the financial markets. CFDs are specifically suited to this smaller scale of investing.

This brings us to the first risk/reward dilemma of CFDs, their volatility. The use of leverage multiplies the risk of trading by increasing the size of potential wins and losses relative to the collateral that is used from your account balance.

The risks of volatility mixed with high leverage are very real, people can lose money if they are not properly educated and risk-aware. But the access for everyday people to profit and loss on the same scale as professionals attracts people to CFDs nonetheless.

Another benefit to trading CFDs is that they are flexible. In the traditional stock market, you buy a stock, hold it for a while and then sell it when you believe the market will turn against you.

Because you do not own the underlying asset, you are only speculating on the future price. This makes it just as easy to buy OR sell a CFD. Going long or short on an asset is an innovation that gives traders the chance to benefit from adverse market conditions.

Why Do Traders Use Futures?

Futures contracts are widely used in the commercial world, mainly as a means to hedge or ‘lock in’ a certain price negotiated in a contract. Futures are an effective hedge against fluctuations in price that might have otherwise reduced the profitability of a deal for a company.

As an example, we will use a Canadian company that exports products to the USA. Their inventory is priced in Canadian dollars, while the finished products that are sold in the U.S. are paid for in U.S. dollars.

Since the costs are in one currency and the receivables are in another, the company is exposed to significant currency risk (and in this case, a rising Canadian dollar against the U.S. dollar).

If the Canadian dollar strengthens between the purchase of the inventory and the time the inventory is sold, the anticipated profit will decline in value.

The export company decides to purchase December Canadian dollar futures, to hedge the anticipated revenue at the current exchange rate. This will effectively “lock-in” that exchange rate for the next month.

If the Canadian dollar strengthens between the time the hedge was entered and the time the sale is finalised, the profit on the futures transaction will offset any decline in Canadian dollar revenue. On the other hand, if the Canadian dollar weakens, the company's revenue will increase but this increase will be offset by a loss on the futures transaction.

When converting the USD to CAD (Canadian Dollars), it will simultaneously sell the December Canadian dollar futures contracts at the current market price.

Conclusion

CFDs and Futures share the same roots, they are great tools that make different trading styles more widely accessible, allowing everyday people to be involved in the financial and commodity markets.

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