CFDs and other types of derivatives
The most common types of derivatives traded in financial markets include:
- Forward and futures contracts
- Options
- Spreads
- Swaps
- CFDs
- Some “exotic” instruments such as barrier options, binary options, chooser options, rainbow options, spread options, and volatility options.
Most of these instruments were originally designed for hedging — meaning they help reduce risks associated with physical transactions or ownership of underlying assets such as company shares.
Each derivative has its own complex mechanics, and before trading them it is important to thoroughly study their specifics, understand how they work, and develop effective strategies. For example, during periods of high market volatility, buying stock options can protect you from adverse price swings in the shares you own. In this way, you hedge your primary position (stocks) with a derivative instrument, such as an option.
In commodity markets forward and futures contracts (both deliverable and non-deliverable — i.e., involving physical delivery of a commodity or serving as indicative contracts) are commonly used to hedge risks associated with the delivery of specific goods, lock in prices on physical contracts via futures hedging, or implement speculative strategies.
Sometimes it makes sense to trade spreads, by opening opposite positions in similar instruments (e.g., buying a WTI crude oil futures contract while simultaneously selling an equivalent Brent crude oil futures contract), expecting the spread (price difference) to move in your favor. There are other ways to construct spreads, such as buying a September gold futures contract and selling an October gold futures contract. This approach allows you to benefit from seasonality in certain commodity markets, while protecting yourself from sharp price swings in the underlying asset — in this case, gold futures contracts.
Swaps are contracts based on the exchange of assets or obligations (e.g., interest payments, payments for goods at a pre-agreed fixed or floating price, etc.). They are usually traded in over-the-counter (OTC) markets and are often negotiated directly between parties, such as a client and a bank.
Contracts for Difference (CFDs) , although derivatives, stand somewhat apart from these instruments. Unlike many other derivatives, CFDs were not originally designed for hedging. Moreover, their price movements largely reflect the dynamics of the underlying assets.
In this article, we will focus on a detailed comparison of just two types of derivatives: options and CFDs.
How do options work?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price. In exchange for this right, the buyer pays the seller a “premium” — a fixed amount for the ability to exercise or not exercise the option in the future. Once paid, the premium is non-refundable, although the option can sometimes be resold to other market participants at a higher or lower price than its initial cost.
Key concepts of options trading include:
Premium: the fixed cost of the option, paid by the buyer to the seller regardless of changes in the underlying asset’s price. It serves as insurance against adverse price fluctuations.
Strike Price: the price at which the buyer can buy, and the seller must sell, the underlying asset if the option is exercised. An option may not be exercised at all. Closing an option position involves selling a previously purchased option or buying back a previously sold one.
Time: Unlike assets such as stocks, options have a limited lifespan. When buying an option, you agree on a time frame during which the buyer may exercise the right. The seller must honor this right if the buyer decides to exercise it.
Option Type: A call option gives the holder the right to buy the underlying asset, while a put option gives the right to sell it. The expiration date marks the end of the option’s validity.
Options also have additional characteristics, such as time decay and the “Greeks” (delta, gamma, vega, etc.), which are metrics showing how factors like asset price or volatility affect the option’s value. Other factors include intrinsic and time value, implied volatility, and sometimes the impact of dividend payments.
Types of Options and a Practical Example
The most common types of options include American and European options (the main types of exchange-traded options), as well as typically over-the-counter Asian and binary options. Beyond these, there are at least a dozen more “exotic” options, often referred to as such in professional jargon, each with its own name.
Let’s look at a practical example of trading options using an American option, the most popular type
Suppose you buy a call option on Apple stock, expecting its price to rise, with a maturity of 30 days. The current share price is $205. You set a strike price of $210, and the option premium is $3 per share. You purchase one options contract, with the minimum lot being 100 Apple shares (ticker: AAPL). The minimum lot is typically 100 shares per contract, which is the standard in options trading.
If within 30 days, for example on day 10, Apple’s stock price rises to $220, you can exercise the option (i.e., use the right to buy the underlying asset at the predetermined strike price of $210). This allows you to buy 100 shares at $210 each, even though their market price is $220, resulting in an unrealized gain of 100 * 10 = $1,000. Your net profit, after accounting for the $300 premium (100 shares * $3 per share), would be 1000 – 300 = $700 gross profit, excluding commissions and fees.
In a negative scenario, if Apple’s stock price falls from $205 to $180 within 30 days, you, as the option buyer, may simply choose not to exercise the option, losing only the $300 premium. Alternatively, you could sell the option before expiration to recover part of the premium and reduce losses further, depending on its residual value. If you had traded the stock directly, your loss would have been (205 – 180) * 100 = $2,500, with potential for even greater losses if the price kept falling. In this case, buying the call option protected you from substantial unexpected losses, with the cost of this “insurance” being the $300 premium.
