CFDs Versus Listed Options Trading

I was at a presentation about options trading from the Cboe in London last night, in conjunction with Interactive Brokers (which offers CFD trading and options trading) and one of the presentations was about options versus contracts for difference.

Now obviously, the agenda is for the Cboe to convince people that options are better because they are an exchange-traded product, as opposed to CFDs.

The key point here is that exchanges make money from listed options trading, where as brokers make money from CFD trading.

So which is best for you?

The difference between CFDs and options trading

CFDs and options both allow traders to speculate on financial markets without necessarily owning the underlying asset, but the way the two derivatives work is fundamentally different.

A CFD provides relatively straightforward, linear exposure to a market. Listed options provide nonlinear exposure and give traders considerably more flexibility over how they construct their risk and potential return.

A Cboe presenter summed up the distinction neatly:

“Options are more involved, but they do provide more control.”

So what’s the difference, and when might you use one rather than the other?

What is a CFD?

A contract for difference (CFD) is an agreement between a trader and CFD provider to exchange the difference between the opening and closing price of an underlying market.

The important feature is that the exposure is linear.

As Cboe explained:

“If your underlying is up 10 points, your CFD would be up 10 points.”

The same applies in reverse.

CFDs are also leveraged products. Instead of paying the full value of a position, traders deposit margin with their CFD provider.

For example, £1,000 of margin at 10% could provide £10,000 of market exposure.

This magnifies both potential profits and losses.

What is a listed option?

An option gives its holder the right, but not the obligation, to buy or sell an underlying asset at a specified price within a particular period.

Unlike CFDs, the relationship between the option price and underlying market isn’t one-for-one.

Options provide nonlinear or “convex” exposure.

The value of an option can be affected by several variables including the underlying price, strike price, time until expiry, implied volatility, interest rates and dividends.

That makes options considerably more complicated than CFDs.

CFDs vs options: where does the leverage come from?

Both products can provide leveraged market exposure, but they achieve it differently.

CFD leverage comes from margin.

Your CFD broker effectively allows you to control a larger position by depositing a fraction of its total value.

Options have embedded leverage.

An options contract can provide exposure to a significantly larger amount of the underlying asset than the premium paid to purchase the contract.

However, the amount of effective leverage can change as the underlying market and sensitivity of the option change.

CFDs are OTC; listed options trade on an exchange

Another significant difference is market structure.

CFDs are over-the-counter products. Your CFD provider is the counterparty and typically determines the prices, spreads and execution available through its platform.

There can also be an ongoing financing charge for leveraged CFD positions held overnight.

Listed options are exchange traded and centrally cleared.

Independent market makers compete for orders, creating a transparent market where traders can see bids and offers.

As Cboe explained:

“There are independent market makers that are constantly competing for orders on this central limit order book.”

Central clearing also reduces direct counterparty exposure between individual buyers and sellers.

Which is riskier: CFDs or options?

Both are high-risk leveraged derivatives, but their risks work differently.

A CFD position can have substantial downside because profits and losses continue to change broadly in line with the underlying market.

With a purchased option, the maximum loss can be limited to the premium paid.

However, options introduce other risks.

Time decay can reduce an option’s value as expiry approaches, while changes in implied volatility can have a major effect on its price even when the underlying market hasn’t moved significantly.

Selling options can introduce substantially greater risks than simply buying them.

Are CFDs or options better?

Neither product is automatically better.

It depends on what you are trying to achieve.

CFDs are relatively straightforward when you simply want leveraged long or short exposure to an underlying market.

Options can be better suited to traders who want to construct a particular payoff, hedge an existing portfolio, trade volatility or precisely define certain risks.

The Cboe presenter summarised the trade-off particularly well:

“CFDs are simpler, but you give up some of that control.”

For experienced traders, therefore, the choice between CFDs and options isn’t necessarily either/or.

They are different tools designed to provide different types of market exposure.