CFDs and futures are very popular investment instruments that allow people to buy and sell assets easily and with controlled risk. However, many investors find themselves lost in the differences between trading CFDs and investing in futures.
Today, we will talk about the differences between contracts for difference and the trading of futures. Also, we will take the pros and cons of investing in these assets.
Futures and CFDs are similar products, but each one offers different products and investing options. There are moments when it is better for a trader to invest in CFDs, but others that an investor will find more compelling the trading of futures.
Basically, a contract for difference, or CFD, is a contract that is a representation of the movement of the price of the underlying asset. The investor is exposed to the changes of value that happen during the time he or she holds the position opened.
On the other hand, a futures contract is an agreement where a trader agrees to buy or sell the underlying asset at a determined price and date in the future. In that case, the price doesn't change, no matter how it moves across the time between the two periods.
Okay, let's move on and talk deeply on both contracts for difference and futures contracts.
A contract for difference, also known as CFD, is a financial derivative instrument where the differences between open and closing trade prices determine the value and profit of the position. With a CFD, the investor doesn't have the ownership of the physical good, product, or security.
While retail investors are now allowed to trade CFDs in the United States, it is possible in most countries around the world. The European Union, England, Cyprus, Australia, and Japan are just a few samples of jurisdictions that allow people to use Contracts for Difference in their investment strategies.
CFDs are currently used as a representation of thousands of assets and pairs in almost all investment markets. The most important and better-regulated brokers in the world will provide investors with contracts for differences in currencies, cryptocurrencies, metals such as gold and silver, selected equities, indices, and even sovereign debt.
How to trade with CFDs?
As the value of a contract for difference is determined by the gap between the opening and closing price of a trade, but not for the ownership of the underlying asset, you will make money if you buy cheap and sell expensive or vice-versa.
Usually, when you buy a pair, or go long, you take that decision with the speculation that the price will go up. Then you will sell it more expensive. On the other hand, when you open a selling position, you believe that the price will go down, so you will make money as you will purchase the pair cheaper.
Let's take as sample the euro against the dollar currency pair. With CFDs, you will make money if you buy the euro against the US Dollar and it goes up. As the picture of the EUR/USD in the MiTrade WebTrader station shows, after buying the EUR/USD at 1.0900, it was close at 1.1160, making a profit of 260 pips.
On the other hand, the same picture highlights a short position from 1.1160 that was closed at 1.1000, making a profit of 160 pips.
Note that the values between the opening and closing prices fluctuated with the position being at times more or less profitable; however, those prices don't affect the final result. Your profit or loss will be determined by the closing price only.
● Not fixed expiration date
● Allow trading of currency pairs, ETFs, indexes, commodities, and even futures.
● Allow the use of leverage, so your profits can be multiplied.
● Easy to trade
● Often not traded on central exchanges
● Significant risks as the price can fluctuate wildly
● Not allowed in the United States
● Require risk management skills
Please note: Margin FX and CFD trading carries a high level of risk and is not suitable for all investors. Please read the Risk Disclosure Statement before choosing to start trading.
A futures contract is an agreement between two or more parties to purchase or sell an asset at a specific price and a set date in the future. That's why it is called Futures, because it is a contract that will be executed in the future.
Long story short, the buyer of a futures contract has an obligation to execute the underlying asset when the contract expires. On the other hand, the seller of the deal has the responsibility to provide the underlying asset at the specific date.
Usually, a futures contract can be presented in markets such as commodities, agricultural goods, energies, currencies, and indices, among others.
There are two ways to use futures contracts. One is for hedgers and the other for speculators. Hedgers use futures as a way to control prices and guarantee budgets with a known price that will get in the next few months.
Speculators, mutual funds and portfolio managers, and traders also trade futures contracts as a way to anticipate price movements on an underlying asset in the future.
Think about a futures contract for oil. Crude producers tend to sell barrels of oil over the next year. So any oil contract will be ready in 12 months. In that way, they guarantee prices, production, and budgets.
At the same time, speculators can buy contracts at a determined price with the assumption that oil prices will rise in the future, then the trader would make money as they exchange contracts for more money.
How to trade futures contracts?
While a trader can buy and sell futures contracts, he or she doesn't need the real good. So, it will sell or purchase the contract or assets before it expires.
As it happens with CFDs, futures contracts provide profits or losses with the difference between the opening and closing prices. Still, the trade must close the position before the expiration date.
Let's take an oil futures contract as an example. An investor who purchases a December contract at $60 per barrel, then it goes up to $70 due to geopolitical tensions in the middle east. The trader will be able to sell the contract for $70 or even $69 per barrel and then make 70 dollars per unit. Ease cake!
Futures contracts pros
● Futures are traded on central exchanges
● Standard contract size
● Fixed expiration date
● Low financial costs
● Producers can hedge and anticipate trends
● High risk
● Investors can lose more than invested
● Futures can make you lose more beneficial and short term trends
Choosing between CFDs or futures contracts is not complicated, but you should have different topics in mind before deciding which instrument is better for you.
While CFDs are traded in brokerages such as MiTrade, the transactions of futures contracts take place on exchange venues.
Overall, futures are more structured instruments that offer less flexibility. They should answer to specific prices and real market flows such as demand and offer of the product that are centralized in particular places or venues.
On the other hand, CFDs are more flexible and allow you to trade the same size of futures contracts with less money. Also, with CFDs, you will be able to keep your trade open as long as you want. The contrary happens with futures, as you should close your contract before the expiration date unless you want to keep the goods.
Another big difference between CFDs and futures is that although both instruments work with spreads, the futures contracts have significantly wider spreads. Also, futures work with bigger contract sizes. As a counterpart, CFDs allow more leverage in the trading of assets.
That being said, CFDs and futures are indeed similar products, but as highlighted above, they have fundamental differences.
One of the most critical topics in trading is risk management. No matter what market you are trading, which instrument you are using, or what strategy you are implementing, all of that should be controlled with risk management.
Following, you will see some tips about risk management and how to keep your trading leverage at decent levels.
Usually, professional forex traders implement 100:1 leverage in their accounts. That means that they can control $100,000 with just a 1,000 investment.
For beginners, the best option is to begin your trading life with a demo account. Then, it would help newbie traders to use 20:1 leverage.
For traders who have solid strategies and good trading plans can also use leverages up to 500:1 and even 700:1, but remember that the more leverage you use, the more exposed your account is.
Never use more than 10% of your account balance in one single trade. Protect your account and diversify your positions.
Finally, allow you to lose money and accept bad trades, never fall in love with negative positions.