What is the Difference Between CFDs and Options

Contracts for difference (CFDs) and options represent two popular leveraged derivative products available to retail traders and investors. While both allow speculative exposure to markets and individual assets without full ownership, there are important distinctions between these instruments in terms of how they are structured and function. A thorough understanding of the key differences is essential for anyone considering trading CFDs or options to do so appropriately and manage risk effectively. 

This article will provide a detailed comparison between CFDs and options, exploring their contractual terms, payoff profiles, breakeven points, and other factors any trader needs to grasp. With clarity on these subjects, readers will be well-equipped to determine which type of derivative product may better suit their objectives, strategies, and risk tolerance.

What are Contracts for Difference (CFD)?

A CFD is an agreement between a buyer and seller to exchange the difference between the opening and closing price of an underlying asset over a set period. Assets available to trade via CFDs typically include stocks, stock indices, commodities, currencies, and cryptocurrencies. At contract expiration, the difference between the open and close price is paid out in cash, not through physical delivery of the security.

CFDs allow leveraged trading by only requiring a fraction of the full value as the initial margin. While this amplifies profits from correct market moves, it similarly magnifies losses when prices go against positions. Traders can speculate on rising or falling prices by going long or short. There are no expiration dates so positions remain open until the trader exits the trade. 

What are Options?

Options are financial derivatives that provide the right, but not the obligation, to buy or sell an underlying security at a pre-determined strike price by a specific expiration date in the future. The two main types are calls, which convey the right to buy; and puts, which convey the right to sell. Options are standardized contracts listed on exchanges, with standardized expiration months and strike prices.

To purchase an option, the buyer pays a premium upfront, while the seller takes on the obligation. Premiums represent the maximum possible loss. Sellers receive this upfront cost hoping the option expires worthless, thus retaining the entire premium. For buyers, options carry limited downside to the premium paid but unlimited profit potential if the underlying moves substantially in their favor.

Payoff Structures and Breakeven Points

CFDs and options provide different payout structures and breakeven considerations:

- CFDs provide linear, unlimited profit potential in both directions without an expiration. Losses are also uncapped but capped at the initial margin.

- Options have defined risk (premium paid) but can yield asymmetric, leveraged payoffs. The breakeven is the strike price plus the premium paid for calls or less the premium for puts. 

- CFD profit/loss occurs directly with the underlying price. Options only pay off if the market surpasses or falls below the strike at expiration.

- Exiting a losing options trade before expiration mitigates losses. CFD traders must ride losses to full closure or margin call.

The potential payoffs vary considerably based on structural differences in how the markets for each derivative product are designed to function. Knowing these payout mechanics is a must for risk-based decision-making.

Leverage and Margin Requirements 

As leveraged instruments, both CFDs and options employ margin capital from traders/investors:

- CFD margin requirements are typically a modest percentage (e.g. 5-25%) of the full trade value depending on volatility and account balance. Leverage can be 30:1 or higher. 

- Options require initial option premium payment which acts as a margin. Maintenance margin to support open positions is typically lower at exchanges, around 20-30% depending on various factors. 

- Leverage in options trading comes from controlling larger positions than funds permit via strategies like vertical spreads which can be 10-20:1. 

- Failure to maintain minimum margins for either product may trigger automatic liquidation by brokers to prevent account losses exceeding deposit balances.

Higher leverage boosts profits but also multiplies risk substantially if trades turn unfavorably. Margin requirements and use of leverage warrant prudent risk management.

Expiration Schedules

While CFDs can remain open indefinitely, options contracts have defined expiration dates. Most equity options expire on the third Friday of each month between 9:30-11:00 am local exchange time. Index options also expire on the third Friday.

Some options tied to futures contracts or futures options will expire during the settlement period for the underlying futures contract. This typically occurs on the expiration date. 

Volatility often rises around news and earnings reports as well as expiration weeks. Traders can look to take advantage of these predictable volatility spikes. In contrast, CFDs lack these short-term expiry dynamics.

Tax Implications 

There are notable distinctions in how CFDs and options are treated tax-wise:

- In most countries, profits and losses from CFD trading are subject only to income tax at ordinary rates rather than capital gains tax rates.

- Options afford more preferential tax treatment. In the US for example, short-term profits under one year are taxed as ordinary income while long term under one year as capital gains. 

- CFD traders pay tax on net profits/losses for each tax year. Options provide 1256 treatment which allows marking open positions to market annually for tax purposes.

- Some countries view CFDs more harshly from a tax perspective but options as a way to gain access to underlying securities. 

Thorough research is advised to comply with local rules as tax treatments significantly impact post-expense returns from each instrument over time.

Conclusion

While CFDs and options both allow speculative leverage, their contractual mechanics, payoff structures, leverage implications, margin use, expiration protocols, and tax treatments contain important differences. A deep comprehension of these nuanced variations is necessary for anyone seeking to deploy capital effectively using derivatives. With clarity on key distinctions, traders can better select tools tailored to their objectives, risk profiles, and investment horizons.