Derivatives trading: CFDs vs equity swaps – what’s the difference?
Learn more about derivatives trading and explore the key differences between CFDs and equity swaps.
Contracts for difference (CFDs) have become one of the most widely used derivative instruments, offering traders a way to gain exposure to price movements in various financial markets without owning the underlying asset. CFD traders speculate on price changes – whether prices rise or fall – across a broad range of markets. However, CFDs are traded on margin, and leverage amplifies both your profits and your losses.
Another commonly used derivative is the equity swap. This is an agreement between two parties to exchange future cash flows based on the performance of an underlying equity or equity index over a set period. Equity swaps are often used by institutional investors for hedging or portfolio management purposes.
Let’s take a closer look at how CFDs and equity swaps differ.
Contract for difference
In simple terms, a contract for difference (CFD) is an agreement between a trader and a broker to exchange the difference in the value of an instrument between the time the contract is opened and when it is closed. When trading CFDs, you don’t own the underlying asset but instead speculate on its price movements.
Key features of CFDs
Leverage
A CFD is a leveraged product, meaning a trader only needs to deposit a fraction of the full trade value. The remainder, known as the margin, is provided by the broker. Trading on margin can amplify both potential gains and losses, so it’s important to understand the associated risks.
Wide range of markets
One of the main advantages of CFD trading is the broad selection of markets available. You can trade global shares, indices, commodities, cryptocurrencies, and forex, giving you access to diverse market opportunities.
Go long or go short
With CFDs, you can trade on opposite price movements: go long or go short on a market’s direction. If you expect the underlying asset to rise in value, you open a long position. If you expect it to fall, you open a short position.
Interest payments and adjustments
A CFD trader may incur charges or receive adjustments depending on their position type. A trader holding a long position typically pays a daily financing charge but may receive dividend adjustments on equity CFDs. Conversely, a short position may earn daily interest adjustments but incur dividend charges.
Keep in mind that financing rates fluctuate in line with market conditions and the volatility of the underlying asset.
No fixed expiry
CFDs generally have no fixed expiry date. Unlike futures or options, positions can be held or closed at any time, provided margin requirements are maintained.
Equity swap
An equity swap is a contract between two counterparties in which they agree to exchange future cash flows over a specified period. Unlike many other derivatives, an equity swap’s value is not directly based on owning the underlying security.
The two cash flows in a swap are referred to as ‘legs’. One leg is typically linked to a floating interest rate – such as the London Interbank Offered Rate (LIBOR) – and is known as the floating leg. The other leg is based on the performance of a share or a stock market index. Most equity swaps involve an exchange between a floating leg and an equity leg.
Key features of equity swaps
- There are several types of equity swaps, but in general, one cash flow is linked to the performance of an individual share, a basket of shares, or a stock index.
- The other cash flow is usually tied to a fixed or floating interest rate, or in some cases, to a foreign equity denominated in another currency.
- Cash flows may be exchanged periodically or at the end of the agreement, depending on the terms set out in the contract.
If a fund manager wishes to exchange the returns from their portfolio for the returns of a market index such as the S&P 500, they could enter an equity swap. Under this agreement, the fund would receive the index return and, in turn, pay a fixed or floating rate derived from their portfolio performance.
Equity swaps may also be used by institutional investors for hedging or managing portfolio exposure. However, they can involve complex structures and specific risks, which means understanding the terms of the contract is essential before entering such agreements.
Past performance is not a reliable indicator of future results.
CFDs vs equity swaps
Let’s look at the similarities and differences between CFDs and equity swaps.
Similarities
- Both CFDs and equity swaps are derivative instruments.
- Each allows traders to speculate on market price movements without owning the underlying asset.
How they differ
#1. Trading assets
| CFDs | Equity swaps |
|---|---|
| CFDs can be used to trade a wide range of markets, including shares, commodities, cryptocurrencies, and forex. | Equity swaps typically involve equities or equity indices only. |
#2. Expiry date
| CFDs | Equity swaps |
|---|---|
| CFDs do not have a fixed expiry date and positions can be rolled over daily, subject to applicable overnight financing charges. | Equity swaps are agreed for a fixed period, with terms predefined at the start of the contract. |
#3. Dividends
| CFDs | Equity swaps |
|---|---|
| Dividend adjustments may apply, similar to traditional share trading. | Dividends are not paid directly within the structure of an equity swap. |
Trading derivatives such as CFDs and equity swaps involves a high level of risk. CFDs are traded on margin – leverage amplifies both your profits and your losses.
FAQ
What is the main difference between a CFD and an equity swap?
The main difference lies in their structure and purpose. A CFD allows exposure to multiple asset classes – such as shares, commodities, forex, and cryptocurrencies – while an equity swap involves exchanging returns based on equities or equity indices over a set period.
Do CFDs and equity swaps both use leverage?
CFDs are leveraged products, meaning you can open a position by depositing only a portion of the total trade value. Equity swaps, however, are typically used by institutional investors and may not involve leverage in the same way as retail CFD trading.
Do CFDs or equity swaps have expiry dates?
CFDs have no fixed expiry date, and positions can usually be rolled over daily, subject to overnight financing charges. Equity swaps, in contrast, are agreed for a fixed term, with all cash flows settled at predefined intervals.