CFDs vs ETFs
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Contracts for difference (CFD) and exchange traded funds (ETF) are two of the most commonly preferred trading options available on the market. In this article, we will look at what they are and how they differ from each other.
What Are CFDs and ETFs?
How does a CFD work? A Contract for difference is a high-risk leveraged product, while exchange traded fund usually tracks an underlying index and is generally considered low-risk. How does a ETF work? An Exchange traded fund is an efficient and low-risk way of gaining access to specific markets.
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.
Active Trading vs Passive Investment
CFD is a contract that enables you to buy or sell at an initial price for a tracked asset, then later reverse and close the contract with an opposite buy or sell in the same tracked asset. Typically, you would use a CFD if you wanted to increase trade leverage. In doing so, borrowing a larger amount for the trade increases your potential gains or losses, making the trade riskier.
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 per cent, so will the EFT tracking the ASX 200.
ETFs can be traded on the stock market, meaning they can be used like listed company shares. Yet, CFD trading is great way to access a broader range of different markets across the world using a broker account. CFDs, on the other hand, offer the great advantage of being able to short-sell an asset group or market. In addition, CFDs enable you to hedge the underlying asset. ETFs, in turn, are typically an investment vehicle used to hold your funds.
Being a high-risk derivative product, which is typically traded on lower time frames from intra-day to intra-week, or perhaps slightly longer, CFDs are ideal when using short-term strategies. You could also potentially use 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.
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. Being leveraged products, CDFs are traded on the intra-day basis.
CFDs are a derivative, thus providing you with a substantial gearing of your investment that allows you to profit from the price change of a much higher security value than you could buy with the same amount of money. 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.
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. Nevertheless, 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.
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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.