Which provides the best opportunities for day traders? Kel Butcher explores.

As well as decisions on how and why to trade, traders are faced with decisions about what instruments to trade. This particularly affects new traders just starting out on their trading journey, as they must choose whether to trade shares, CFDs, futures, forex, options or some mixture of these products. It can also apply to more experienced traders who may have years of experience trading some instruments but wish to move into trading others to diversify their exposure and apply their skills in other markets. This article compares CFDs and futures to help you determine which may suit your trading style and trading system.

What are CFDs?

A contract for difference (CFD) is an agreement between two parties to exchange the difference in price between the opening and closing price of a contract that is based on the price of an underlying security (such as a share price). The profit or loss is determined by the difference between the two prices at which the contract is bought or sold. In essence, the CFD provider agrees that if the trade shows a profit the provider will pay this amount to the trader. If the trade is a loser, the trader pays the difference to the CFD provider. Hence the term ‘contract for difference’. In return for the provision of this service, the CFD provider charges interest on the money ‘lent’ to you to buy on margin, and pays you interest on any short positions. Interest calculations need to be taken into account on bought, or long, positions, because interest is calculated on any positions held overnight. Interest is calculated at the full face value of the position, and not just on the amount of margin you have used.

What are futures?

Present day futures contracts evolved from standardised forward contracts developed by the Chicago Produce Exchange. Whilst they retain the basic concepts of these original contracts, they are now very specific contracts that cover a wide range of markets and related products. The underlying principle that forms the benefit of standardised futures contracts is that at contract expiration date the holder of the contract (the buyer) has the obligation to take delivery under the terms of the contract, whilst the seller is required to make delivery. From a trader’s perspective, this is of little relevance, because profits and losses are incurred by buying and selling the futures contract prior to the expiry date.

Because futures are interchangeable, many people who never intend to either make or take delivery of the underlying commodity or instrument can buy and sell futures contracts. Traders and speculators buy and sell futures contracts as a way of making a profit from price fluctuations as market conditions change. They are taking advantage of a key feature of futures trading, the ability to eliminate an open position by buying or selling the opposite side of the existing open position before the expiry date – a process known as ‘offsetting’.

A futures contract is a legally binding, standardised agreement to buy or sell a standardised commodity or financial instrument of specific quality and quantity on a specified future delivery date at a given location. The only variable is price. Some futures contracts, such as wheat and live cattle, call for physical delivery, whilst others, such as eurodollars and the S&P 500, are cash settled.

CFD margin trading

To trade CFDs you need an account with a CFD provider. Your cash in the account is collateral cover (also referred to as ‘margin’) for the trades you make. Trades are conducted on a margin basis, allowing the trader to participate in trades without having to pay the full purchase price of the shares or futures contract. You may for example, wish to purchase 1000 XYZ shares at, say, $40 per share, with a total value of $40,000. To purchase 1000 XYZ CFDs through a CFD provider offering 10 per cent margin, would mean lodging $4000 as initial margin with the CFD provider. This is referred to as ‘initial margin’. It can vary from as little as three per cent for highly liquid stocks and index CFDs to 80 per cent for smaller, illiquid stocks. The margin amounts move in and out of your account as trades are opened and closed.

Margin trading with futures

Commodities, equity indexes, interest-rate products and some currencies are traded on margin using futures contracts. The margin lets traders control large amounts of a given commodity with relatively small amounts of capital. For example, one wheat futures contract, representing 50,000 bushels of corn (worth about $US38,000 at the time of writing) can be traded with an initial margin of $US4050 or just over 10 per cent.

Leverage

CFDs and futures are both leveraged instruments. For a small amount of your capital you can control, or have exposure to, a large face-value position. In the previous example, by using just $4000 of your own capital, you are able to gain exposure to a $40,000 share position by using a CFD; or to a 5000-bushel wheat contract by using a futures contract. In both cases you have paid 10 per cent of the face value of the position and made use of the available margin to increase your exposure to these markets. If the same position were opened using five per cent leverage, or a multiplier of 20, you would have exposure to the $40,000 position using only $2000 of your capital. If the position were opened using 50 per cent leverage, a multiplier of two, you would need to use $20,000 of your capital to control the $40,000 position. Leverage can be utilised in two main ways: by using available capital to trade more positions, or by trading larger positions with the same amount of capital.

Using capital to trade more positions

With $20,000 in an account with a stockbroker, you would be restricted to two positions of equal value of $10,000 each, as there is no leverage. Shares are bought on a leverage of 1:1. If trading CFDs with a CFD provider offering 10 per cent leverage, it would be theoretically possible to trade twenty $10,000 positions, for a total exposure of $200,000. That is $20,000 multiplied ten times over. Calculated another way, each $10,000 position requires a 10 per cent or $1000 margin, so 20 times $1000 equates to the trader’s $20,000 account balance.

The CFD provider may have checks and balances in place to prevent your achieving such high exposure, but the point is, you can have much greater exposure than would be possible if trading the underlying instruments without the use of leverage. Futures traders can make use of leverage similarly, by using the margin to participate in a greater number of open positions than would be possible without the use of margin. In the wheat example with a face value of around $38,000, a trader with a $20,000 account would be unable to buy or sell a wheat contract if it weren’t for leverage.

Trade larger positions with the same amount of capital

You may decide to trade only a small number of positions, say two, as in the original example, but they can now be traded at a much larger face value. Instead of two positions with a face value of $20,000 each, it is theoretically possible to trade two positions with a value of $100,000 each, requiring a $10,000 margin for each position. Leverage of course is a double-edged sword, greatly augmenting wins, but quickly enlarging losses and wiping you out if you are over-exposed and over-leveraged. The most important rules must be to always preserve capital and to fully understand the effects leverage can have on your account balance if used incorrectly.

CFD brokerage rates

Whilst brokerage rates vary according to the broker, a typical rate is somewhere around $8 to $10 for a trade with a face value of $8000 to $10,000, then 0.1 per cent for trades with a greater face value. A trade in 4000 shares of XYZ company at $5.00 per share, with a face value of $20,000, would incur brokerage of around $20. Compared to typical share trading where brokerage rates range from $15 per trade with deep discount brokers to more than $80 for full service brokerage, CFD trading has obvious benefits for active traders of these products.

Futures brokerage rates

Again, brokerage rates vary with different brokers. Many brokers also offer significant discounts to clients who trade large volumes and/or are regularly active in the markets. Rates may vary from around $15 to $40 per trade depending on the client’s requirements. Traders who are self-executing trades on an online platform and placing large volumes of trades can negotiate rates per trade of less than $8.00. Similar to CFD brokerage rates, futures brokerage rates are much less than typical share brokerage rates. Ease of use, low transaction costs, and ability to trade through online trading platforms are some major reasons traders are attracted to trading both CFDs and futures contracts. Over the counter (OTC) versus exchange traded Futures contracts are traded on registered and regulated exchanges, such as the Chicago Board of Trade (CBOT), Sydney Futures Exchange (SFE), and the InterContinental Exchange (ICE).

Futures users and traders are protected from contract default by the guarantee system put in place by futures exchanges. The exchange clearing house is a separate entity that acts as third party to every futures transaction, severing the direct relationship between buyers and sellers so the two parties never create a direct financial obligation to one another. Instead, the buyer and seller each create an obligation to their broker, who in turn has an obligation to the clearing house. Just as brokers require margin from their clients to allow trades to be undertaken, brokers in turn must deposit a performance bond or margin with the clearing house. The margins are ‘good faith’ deposits required to fulfil contract obligations. The margins are determined on market risk and as such are an important component of the sound financial structure of futures markets.

In comparison, most CFDs are traded in a synthetic market known as ‘over-the-counter’ or OTC, where the CFD broker or provider is also the market maker. That is, the providers attempt to mirror the price of the underlying security by offering bid and ask prices to their clients through their own online trading platform. CFDs are also traded through Direct Market Access (DMA) CFD providers. These trades are dealt directly into the market by an online trading platform. Like OTC, the DMA CFD provider is also the counterparty to the client’s position and each trade, though the trade is 100 per cent hedged with the underlying share position. Some exchanges, such as the ASX, offer exchange-traded CFDs.

Other points to consider

When trading commodities and financial instruments such as equity indexes and interest rate products, liquidity is generally greater and the bid-ask spread is generally tighter in futures markets than in CFD markets.

When trading futures contracts, lot sizes are fixed according to the terms of the futures contract. CFD lot sizes can be ‘created’ by the market maker. It is not uncommon to see ‘mini’ and half-size CFDs made available over some of the larger futures contracts. This has benefits for smaller retail traders who may be daunted by trading a full-size crude oil contract, but can still participate in an anticipated price move in that market through a smaller CFD contract.

CFDs are available over a huge range of instruments, from shares to commodities, equity indexes and even forex. They can generally be accessed from the one broker-provided platform, giving easy access to a wide variety of markets through one account.

When holding a long or bought CFD position you must pay interest on the face value of the contract. For most day- and shortterm traders this is not an issue, but it is still a cost that must be accounted for. The interest component of futures contracts is priced into the asset to reflect the fact that it is priced according to a delivery date some time in the future.

CFDs and futures contracts are both popular and liquid instruments, traded extensively throughout the world. Both are derivative instruments whose prices are derived from that of an underlying financial instrument or commodity such as a share, commodity or interest rate. Both are similar in style but have some key differences that need to be understood before trading them. They both allow the use of leverage, offering the potential to increase returns for the active and educated trader.

Trade well.

Kel Butcher is a full-time futures, equities, forex and derivatives trader. He is the author of ‘20 Most Common Trading Mistakes and How You Can Avoid Them’, ‘A Step-by-Step Guide to Buying and Selling Shares Online’, and ‘Forex Made Simple – a Beginner’s Guide to Foreign Exchange Success. He also acts as a mentor and coach to other traders. Kel can be contacted by email at This e-mail address is being protected from spambots. You need JavaScript enabled to view it

This article was originally published in the Jul/Aug 2011 issue of YourTradingEdge magazine. All rights reserved. © Copyright 2011, Your Media Edge Pty Ltd.
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