The Differences Between CFDs and ETFs - How They Work
What Are CFDs vs. ETFs?
Contracts for difference (CFD) and exchange traded funds (ETF) are two of the most commonly preferred trading options available on the market.
A Contract for Difference is a high-risk leveraged product. It is a contract that enables you to buy or sell an underlying asset, then later reverse and close the contract with an opposite buy or sell in the same tracked asset. Ultimately, CFDs allow you to trade on the price changes of assets without having to purchase the asset outright.
As a derivative (the term refers to financial instruments where the value is 'derived' from an underlying asset, like a share or commodity), CFDs also give you access to gearing, or leverage. One of the benefits of this is that you can access a high-value trade for a relatively low deposit (as little as 1/30 of the value of the underlying asset). This then increases the relative profits when compared with your deposit, but it also increases the risk.
Because CFDs are complex instruments and involve high risk of losing capital due to financial leverage, CFD traders might lose a lot of money if their position in the market goes wrong. But if the opposite is the case, a trader may earn a lot. CFDs are also subject to interest charges for the period that you hold them for.
Exchange Traded Funds, on the other hand, usually track an underlying index (like the previous example on robotics and AI) and are generally considered low-risk.
Why are ETFs considered to be low risk? One reason is because they create instant diversification for traders.
For example, Australian equity or Australian fixed income ETFs track indices, offering instant diversification benefits across a portfolio of underlying assets. The underlying assets are held on trust by an external custodian on behalf of the investor. This minimises counterparty risk from the ETF issuer.
ETFs are considered low-cost investments, as there is only a small annual management fee. Also, there are no ongoing interest fees as your own funds are required to invest in ETFs. This is quite the opposite with CFDs, which only require you to invest the margin total, and if held overnight, incur interest charges on the leverage obtained. In contrast, with CFDs you gain access to a product that tracks the price of the underlying asset. Generally speaking, you do not receive franking credits.
Should You Trade ETFs? Active Trading vs Passive Investment
One of the biggest differences between CFDs and ETFs is that the former are generally used more for speculation, whereas the latter for longer-term investment.
CDFs are usually traded on a short term basis, ranging from scalping (or carrying out trades in just a matter of minutes), to day trading (opening and closing trades within a day) to swing trading (holding trades for a number of weeks).
Because they are leveraged, traders have the opportunity to realise large profits (and losses) very quickly. This makes them very high risk, and often more suitable for experienced, active traders (or people who want to become experienced, active traders).
As a CFD trading alternative, ETFs are better for those seeking a passive investment, usually, a buy-and-hold type strategy. For instance, if the ASX 200 increases or decreases by 15%, so will the EFT tracking the ASX 200.
ETFs can be traded on the stock market, meaning they can be bought and sold like listed company shares.
Note that it is possible to trade ETF CFDs with Admirals, as well as investing in ETFs directly. Trading an ETF as a CFD gives you the benefits and risks of leverage, meaning you can still access these investments for short-term, active trading, while investing in the ETF itself is better for those who are interested in more passive, long-term investing.
For these reasons, both CFDs and ETFs are very attractive to investors. If you want to try CFD and ETF trading, make sure to develop a long-term investment plan as well as understand all the risks involved prior to making an investment.
Can You Trade Both ETFs and CFDs?
It is possible for a trader or an investor to have a strategy that features both ETFs and CFDs.
One example is using a CFD to hedge exposure in ETFs, but the same cannot be said for the reverse. One downside of ETFs is that you can gain exposure to certain sectors or the entire share market, but generally there is no expert selection in the underlying asset portfolio of the ETF.
If this is the case, it means that ETF stocks might be attractive to an investor. Additionally, when a particular sector is hot, it can bounce the share price up for that particular sector. The prices might go further up if the index includes companies in that sector, as the fund will be forced to buy more shares in those companies.
When it comes to ETFs and indices, you will occasionally see an inverse correlation between them. ETFs that behave inversely to indices will earn value (go up) when the index drops in value (goes down). ETFs are also available in a form that can multiply the difference. For example, an ETF can go up twice as much as the index can. This is what many investors and traders really look for.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
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