CFDs vs Futures | Differences Explained

There is some overlap between CFDs and futures, but the distinctions between them are significant. Let’s look at 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 generally used by different types of investors. Outside of bonds, individual equities, and ETFs, they are two of the most popular ways to trade. Moreover, each can be used to invest in indices, currencies, and commodities, representing some of the biggest markets in the world. Both types of financial instruments are easily accessible through online trading platforms, making them extremely versatile and some of the most widely used financial tools.

CFDs explained

CFD simply stands for Contract For Difference. Most significantly, when entering a CFD trade, you do not buy the actual asset but make an agreement with your broker. Essentially, by that agreement, you make a bet on where the future price will go.

You can either bet long (that the price will increase) or short (you expect the price to decrease). If you turn out to be right, the broker will pay you the difference between the price of the asset when you entered the contract and when you closed the trade.

Of course, if your research and intuition led you astray and the price goes in the opposite direction to what you hoped, you will lose money.

Futures explained

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

This purchase or sale is not optional; heavy penalties apply if you cannot fulfil your obligations. However, futures are more frequently used as a form of insurance rather than for gambling. They often serve as a hedge against large, unexpected price movements of an asset or security.

Both of these instruments are derivatives, meaning that their value is based on some more tangible underlying asset that forms the basis of these contracts. This, in turn, implies that you can bet on the future price of a huge quantity of some asset (for example, 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 distinctions between futures and CFDs. Each may, at different times, be more suitable for your circumstances and investment goals.

Spreads

“The spread” is the difference between the purchase and sale value of an asset. In times of high market volume, spreads tend to decrease. When the market suffers from low liquidity, spreads generally increase. When trading CFDs, traders will typically only pay a spread, or whatever difference their broker offers between buying and selling prices. With futures, however, they have to cover the spread charged by the futures exchange plus a commission charged by the broker.

Holding period

CFDs are designed to be short-term contracts and are most cost-efficient for holding periods under one year. This is because they incur overnight fees known as “financing costs”, basically the interest you pay for trading on margin. In other words, 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 already taken into account depending on how long the future contract has left to run. It is common for futures traders to hold their positions for several weeks, though the contracts may 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 an open trade without any need to close a position and roll it into the next contract. Futures, onthe 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, namely everyday people who use their own money to invest in the financial markets. CFDs are specifically suited to this smaller scale of investing due to the ability to trade on margin.

This brings us to the first risk/reward dilemma of CFDs: their volatility. The use of leverage multiplies the risk involved in any trade by increasing the size of potential wins and losses relative to the cash collateral in the form of your broker account balance.

Market volatility mixed with high leverage can be a dangerous combination; it’s easy to lose excessive amounts of money for thse who are not properly educated and risk-aware. But the ability for everyday people to access profit and loss on the same scale as professionals nonetheless attracts amateur traders to CFDs.

Another benefit to trading CFDs is that they are versatile and can be traded in both rising and falling markets. 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. The expectation is that any shares you buy will increase in value.

Because you do not own the underlying asset when working with a CFD, you are only speculating on the future price. This makes it just as easy to buy OR sell a CFD. There is nothing stopping you from going either long or short on an asset, giving traders the chance to benefit in a market where equities are suffering.

The benefits and uses of 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 in advance of the transaction actually occurring. Futures are an effective hedge against fluctuations in price that might have otherwise reduced the profitability of a deal to a company.

As an example, let’s say a Canadian company exports products to the USA. Their inventory is priced in Canadian dollars, while the finished products 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 importing company is exposed to significant currency risk (in this case, a rising Canadian dollar against the U.S. dollar). If the Canadian dollar increases in value between the order being placed and the time the inventory is paid for, its anticipated profit will decline in value.

The export company decides to purchase 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 or longer.

If the Canadian dollar picks up between the time the hedge was entered and the time the sale is finalised, the importer does not make extra money (which was never the point), but nor does a fluctuating currency harm them much. The profit they take on the futures transaction simply offsets any decline in U.S. dollar revenue. On the other hand, if the Canadian dollar weakens, the company’s revenue will increase, though this increase will be offset by a loss on the futures transaction.

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

Conclusion

CFDs and Futures share the same roots, and they are great tools that make different trading styles more widely accessible. They allow everyday people with limited capital to be involved in the financial and commodity markets. However, they tend to be more risky than bonds and equities and require some care in their use.