Distinguishing CFDs and Futures in Financial Trading

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CFDs (Contracts for Difference) and Futures are both popular derivative products you can use to speculate on financial markets. Let’s explore the differences between CFDs and Futures, and determine which type of trading is best for your strategy.

Key Differences

In this article, I will outline 5 key differences between CFDs and Futures, summarized in the table below:

Expiration Date

Futures contracts have an expiration date when the underlying asset will be traded. Different futures contracts for the same underlying asset have various expiration dates, each active for a specific period. For instance, US stock index futures typically expire on the third Friday of every month. Once expired, the contract can no longer be traded, and traders must settle the contract by delivering the physical asset (for commodity, stock, bond futures) or cash settlement (for index futures).

Conversely, CFDs have no expiration date. Through CFDs, you agree to pay or receive the price difference between the time you open and close the position on the underlying asset.

Many CFDs are based on underlying futures contracts (e.g., oil CFDs are based on the nearest month oil futures contract), which only hold value before they expire. Therefore, these CFDs feature a “rollover” mechanism, whereby the next month’s futures contract is used as the new underlying asset before the current one expires.

Underlying Assets

Futures can be based on various underlying assets. Commodity futures are the most common, but stock index and currency futures are the most popular with high liquidity in the market. Stocks and bonds can also serve as underlying assets for futures.

With CFDs, the range of underlying assets is broader, including stocks, indices, commodities, currencies, cryptocurrencies, options, bonds, and even futures contracts themselves.

Asset Ownership

When you participate in futures contracts, you have two choices at expiration:

• Physical settlement: Delivery of the physical assets (not applicable to index futures).
• Cash settlement: Instead of receiving the asset or ownership rights, you settle with a cash amount equivalent to the price difference at contract execution versus expiration.

With CFDs, you always settle positions in cash and never own the underlying asset.

Trading Method

Futures are traded on centralized exchanges, where traders gather to execute buy and sell transactions of assets. These exchanges are tightly regulated to ensure product quality and smooth transaction processes between parties.

The Chicago Mercantile Exchange (CME) is perhaps the most famous futures exchange. Futures traded on CME cover a range of underlying assets including agriculture, energy, stock indices, foreign exchange, interest rates, metals, real estate, and even weather futures.

CFDs are traded over-the-counter (OTC), where you deal directly with brokers or providers. OTC trading is typically more flexible compared to centralized exchange trading, which is more strictly regulated. This flexibility means you can create custom transactions tailored to you and your trading strategy.

Trading Volume

Because futures are traded on large exchanges, the contracts are standardized in both quality and quantity. Trading volume for futures is typically large, as they are designed for institutions.

CFDs are also traded in standardized lots based on the underlying asset. However, you can trade CFDs with smaller volumes.

For example, a typical gold futures contract is equivalent to 100 ounces, meaning you need $188,300 at the time of writing to open a gold futures position. Conversely, while a gold CFD also equates to 100 ounces per contract, you can trade with a smaller volume, with a minimum of 0.01 lots.

Similarities Between CFDs and Futures

It is also important to note that futures and CFDs share many similarities. Both are:

• Derivatives: Built on assets from the underlying market. This means you can indirectly trade the underlying market without owning the referenced assets.
• Speculative: Allowing you to go long or short at market prices.
• Leveraged: Requiring only a portion of the contract value as margin. Profits and losses are magnified according to the leverage you use.

CFD Trading Mechanism

When you go long or short a CFD, you enter a contract to benefit from the price difference of an asset. You go long if you believe the asset will increase in value and short if you think it will decrease.

To determine profit or loss, you need only consider the difference between the opening and closing prices, the trading volume, and the value of each contract.

For example: You go long 10 FTSE 100 index CFDs at 6,000 with 1:100 leverage. Each contract is worth £10 per index point. Thus, the position value is £600,000, requiring a £6,000 margin. You can easily calculate your profit or loss as the market moves: a 1-point rise equals a £100 profit, and a 1-point drop equals a £100 loss.

If the FTSE 100 index rises 25 points and you close the position, you immediately gain £2,500. Conversely, if it drops 30 points, you lose £3,000 upon closing.

Futures Trading Mechanism

A futures contract is an agreement to buy or sell an asset at a specific price determined at the position’s opening, on a specific future date (usually the expiration date), regardless of the asset’s market value at that time.

If you want to buy an asset in the future but fear its price will rise compared to the current time, you go long futures. At expiration, you buy the asset at the initial position price.

For example, you go long WTI crude oil futures at $50/barrel while the current WTI crude oil price is $54/barrel. At expiration, you can still buy oil at the initial position price ($50/barrel), regardless of the market price. Hence, you have the opportunity to buy WTI crude oil at a cheaper rate ($50/barrel) than the market price ($54/barrel).

Pros and Cons of CFD Trading

Pros:

• Access to over 17,000 markets, including stocks, indices, commodities, and currency pairs.
• Leverage allows you to magnify profits and requires less margin.

Cons:

• Leverage is a double-edged sword: it magnifies risks as well as profits.
• Requires sufficient knowledge to trade effectively. Demo accounts can help you learn.
• Overnight positions incur overnight fees.

Pros and Cons of Futures Trading

Pros:

• Hedge your portfolio, protecting you from adverse market movements.
• Easier long-term trading since you don’t incur overnight fees like with CFDs.
• Leverage magnifies profits and requires less margin.

Cons:

• Futures are suitable for more experienced traders due to their complexity.
• Futures prices are only valid until expiration, complicating long-term analysis.
• Leverage can magnify losses, making risk management strategies crucial.