If you already know about CFDs (contracts for difference) and know how they work but are wondering if they are a worthwhile investment, you should first learn about derivatives. CFDs are a specific type of derivative among many different varieties, all of which we will also introduce to you. So, we will, first of all, define what a derivative contract is, then what other types of derivatives there are, and what their advantages and disadvantages are.
What is a derivative?
A derivative is a contract, which acts as a security, that bases its value on the value of an underlying asset. This underlying asset can generally be anything that the trading market values. Whether it is stocks, commodities, currencies, there are many options. They can be based on one or a grouping of assets, something which is up to the participants. These contracts are made to put agreements into place for trades between two parties. These sorts of trades are usually established by a mediator, a broker, to deal with all the details.
The dealers can thus take advantage of price changes of an asset without ever having to own that asset. This makes these types of contracts very attractive to traders. Traders can enter the contracts with small investments, as they do not have to pay the price of the asset. Also, since they do not ever have to own the asset, they will not have to convince other traders to buy the asset. With a real asset, they might lose a lot of money if they do not manage to convince people to buy at a critical time. With one of these derivative contracts, they can make sure that a trade goes through as long as the necessary conditions are met.
So, if a trader’s predictions turn out to be correct, they can guarantee themselves a profit. We should mention though that these contracts can be done either over-the-counter (OTC) or through an exchange. The exchange is far more regulated, and defaults are very unlikely to occur here.
So, now that we know the basics of what a derivative contract is, what kinds of derivatives are available to you?
Types of derivatives
These are the most basic type of derivative you are likely to come across, and most likely the oldest. Originally this would have just been a formal agreement between people, but obviously, over time, this became a contract. It is essentially an agreement that someone will sell an asset at a set future date. Regardless of the situation at the time of the date, the party must sell the asset to abide by the agreement. These contracts are highly unregulated and risky, so much so that most do not even involve brokers. The two parties deal directly with each other, and all the details are dealt with directly. This means that, while you can come up with any sort of trade the other party agrees to, you will have to be very careful.
You will need to have a high amount of trading knowledge to ensure success in these sorts of trades. No one will be holding your hand. The only person you could is the one you are making the deal with, so they may not have your best interests at heart. Since there is no regulating body, however, you can fortunately change your contract if you made a bad decision, if the other party agrees of course.
These types of contracts are only really one step beyond forward contracts. They also revolve around setting up the sale of an asset for a future date. The one change is that they are regulated. They are carried out on the exchange, so there are laws restricting what it can do. For one, you usually choose from contracts with pre-set conditions, nothing you can adjust for yourself. Secondly, you cannot change the contract once it has been set.
As you can see, they are not very useful for individual traders. It gives them very little wiggle room, and profits are unlikely to be considerable. This is why you will most likely see large companies or hedge fund managers use them. If they are bought in mass bulk, they can make considerable profits. Since it is such a regulated market, investors are likely to make reliable and considerable profits once they themselves invest a lot of funds.
These derivative contracts differ quite considerably from the previous two. Essentially, it gives one of the parties in an agreement some… well, ‘options’. Once the contract reaches its expiration date, a trader can choose if they want to go through with the trade. This could be at either a call (buying) or a put (selling) position. They can also combine a long or short position. These are most likely to be set up through brokers, as the details can be quite complicated.
This option is great for people who are unsure about where the market is going. If a trade goes sour, and the value of the asset is not what they expected, they can choose to step out of the deal. However, this does not come without consequences, as they will have to pay a considerable premium if you do decide to go through with it. So it is still in their best interests to trade wisely. The complexity of these contracts means they are still best avoided by completely novice traders.
These are the most complicated common contract you will come across. In these sorts of contracts, two parties can exchange cashflows, payments, or instruments for a set amount of time.
We can give a quick example of how they work. They are mostly usually used for loans and bonds to exchange the interest rates. Basically, one company worried about the interest rates on a bond can go to someone else to exchange the earnings by interest. One of the cash flows, towards the large company, will be fixed. The large company will then pay a variable rate to the other party, depending on how the interest rate does. These contracts are mainly used to ensure against risky interest rates.
As you will have quickly understood, these are quite complicated contracts. We do not recommend them for beginner traders as it will have them following rather complicated concepts in economics. So we recommend new traders go somewhere else, namely CFDs.
Why choose CFDs?
CFDs offer new traders much to compensate for the shortcomings of all the previous option. Although they can be complicated, they can be exchanged through brokers, so you will not have to be too deep in the details. They are not under much regulation, so you have room to experiment and learn. The fact that there is no set expiration date means you can continue in the investment until you can reach a desired outcome. You can also enter with very little cash, and trade with margin, making them quite accessible.
We should mention that they do have some drawbacks you should consider. The main one is that the combined costs the brokers require means you are unlikely to make huge profits. This is especially true if you are investing small. Traders only make proper with big investments.
So, overall, CFDs are recommended to new traders to learn how the market works. You have great flexibility to make the sort of contract you want. You are unlikely to make huge profits, but you will learn a lot without risking too much. From there on, you can move onto more profitable types of contracts, or invest more in CFDs.