Derivatives trading: CFDs vs equity swaps – what’s the difference?
09:27, 12 September 2018
Contracts for difference, or CFDs, have been confidently paving their way in the investment world, becoming one of the most popular and widely-used trading tools.
By choosing CFDs, a trader gains the ability to profit from price fluctuations of fast-moving financial instruments; whether their price goes up or down.
CFDs, being one of the most popular trading tools – offering leverage and the possibility to trade on margin – provide outstanding opportunity for ordinary people to enter the world’s top financial markets, without the need to spend a fortune on a single trade.
Another popular instrument, attracting traders’ attention, is an equity swap. It is also a derivative instrument, in which two parties pre-agree to exchange a set of future cash flows at a predetermined date.
As these two types of derivatives are often mixed up, let’s look closer at CFDs vs equity swaps.
Contract for difference
To cut a long story short, a CFD is an agreement between a trader and a broker for the difference between the instrument’s value at the start of the contract and the end of it. When buying CFDs you don’t actually buy the underlying asset, but ride the instrument’s price swings instead.
Key features of CFDs
Leverage
CFD is a leveraged product, meaning that a trader needs to deposit only a small percentage of the full cost of the trade. The rest is provided by your broker and is called margin. Trading on margin magnifies your potential return on investment. Still, you should always consider the risks, which may also be high.
Wide range of available markets
One of the major advantages of trading CFDs is a vast choice of available markets. You can trade on top global shares, indices, commodities, forex, and cryptocurrencies– the hottest new trend in trading.
Go long, go short
With CFDs you can trade on opposite price movements: go long, and go short on a market’s direction. If you believe the underlying asset will rise, you open a long position, and if you think the price will fall, you go short.
Interest payments
Note that a CFD trader will incur benefits and costs, regarding his choice of either short or long positions. A trader with a long positon will bear daily payment costs, but will get a dividend payment from the underlying equity (like with ordinary shares). Vice versa, a trader with a short position will bear a dividend payment costs, but will get daily interest payments, while short-selling the equity. Also, you should keep in mind that interest rates are fluctuate, depending on the market’s and a particular asset’s volatility.
No expiry date
Contracts for difference do not presuppose an expiry date. Unlike futures or options, you can always renew and prolong your CFD trades for as long as you want to.
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Equity swap
An equity swap is a contract between counterparties, in which they exchange future cash flows over a determined regular period. Unlike other derivatives, equity swap valuationdoes not derive from an underlying security.
The two cash flows of a swap are known as “legs”. One “leg” is usually pegged to a floating rate – for example, LIBOR (The London Inter-bank Offered Rate), and is commonly known as the “floating leg”. The other leg is based on the performance of a stock or a stock market index. Most equity swaps presuppose a floating vs. equity leg exchange.
Key features of equity swaps
- There are various types of equity swaps, however one cash flow should be based on the performance of an equity, basket of equities, or a stock index.
- The other cash flow should be based on a fixed or floating interest rate, or a foreign equity, denominated in a foreign currency.
- The cash flows are usually exchanged at the end of the swap agreement or in some periods, stipulated in advance.
There are numerous equity swapexamples. For instance, if an ABC fund’s portfolio manager can swap the fund’s returns for the S&P 500 index returns, he will enter into a swap contract, in which he would get the return of the S&P 500 and pay the other party a fixed rate, obtained from his portfolio.
Equity swaps also offer some tax advantages for individuals. If you own $1million worth of stock of the ABC company and predict that the stock value will increase over the 12 months, you can enter an equity swap agreement. According to it, you will pay the counterparty the total return you receive from your ABC shares annually, and take the 3-month LIBOR rate in return. You also won’t have to report any capital gains on your stock.
CFDs vs equity swaps
Let’s have a look at the similarities of CFDs vs equity swaps.
- Both, CFDs and equity swapsare derivative instruments
- CFDs and equity swaps allow traders to benefit from the financial markets’ ups and downs, without the need to own the underlying asset
How they differ
#1. Trading assets. CFDs vs equity swaps
CFDs | Equity swaps |
CFDs can be used for trading various kinds of assets, including shares, commodities, forex, and cryptocurrencies | Equity swaps involve equity or equity indices only. |
#2. Expiry date. CFDs vs equity swaps
CFDs | Equity swaps |
CFDs have no fixed expiry date and positions can be renewed each trading day indefinitely (paying an overnight fee) | Equity swaps are performed for a fixed, pre-determined period. |
#3. Dividends. CFDs vs equity swaps
CFDs | Equity swaps |
May be paid, like in traditional shares trading. | No dividends involved |
No matter what you choose in the pair CFDs vs equity swaps, please, always bear in mind that many retail investors lose money when trading. You should consider whether you can afford to take the high risk of losing money.