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Derivatives 101: What are CFDs and Options?

I like to refer to the current retail investing frenzy as a 'DIY investor revolution', powered by the likes of Robinhood Markets (NASDAQ: HOOD), Interactive Brokers (NASDAQ: IBKR), and BlackBull Markets. Within this revolution, we have seen retail investors adopt derivatives trading with a level of sophistication on par with 'professional' traders.

For those that haven't caught on to the revolution, I thought it would be a good idea to detail the basics of a couple popular derivatives. I hope to show what many retail investors have already found out for themselves; CFDs and Options are not all that complicated or mysterious.

What is a derivative?

Derivatives, such as CFDs and Options, are 'derived' from traditional financial instruments such as stocks, commodities, and foreign exchange. Typically, derivatives take the form of a contract that takes its value from an underlying asset, such as the spot price for one troy ounce of Gold (XAU/USD).

Derivatives are used by investors worldwide to take advantage of investment opportunities or hedge efficiently against uncertainty.

What is a CFD?

CFDs Derivatives

CFD stands for 'Contract For Difference'. As the name denotes, a contract's buyer and seller agree to compensate the other the difference between the current price of an asset and its future price.

The buyer of the CFD is said to be taking a long position in the underlying asset (i.e., believes the asset's price will rise). In contrast, the seller of the CFD is said to be taking a short position (i.e., thinks the asset's price will fall). If the price of the asset rises, the seller of the CFD will compensate the buyer. If the price of the asset falls, the buyer of the CFD will compensate the seller.

CFDs exist for various securities, including stocks, indices, commodities, and, most popularly, foreign exchange.

There is one primary reason investors choose to trade CFDs over other derivatives such as Options and Futures. With CFDs, traders can generally trade with greater leverage than other derivatives, allowing larger positions with smaller deposit sizes. Consequently, gains and losses can be magnified more easily when trading CFDs.

What is an Option?

Options Derivatives

The handy thing about derivatives is that their titles aptly describe what they are and do.

An Options contract gives the buyer the 'right', but not the 'obligation' to buy or sell a set quantity of an asset from/to the contract's seller before a given expiration date.

Option contracts exist for various securities, the most popular being Indices and Stock Options (i.e., an Options Contract for 100 shares of Tesla (NASDAQ: TSLA)).

Options come in two flavours; Calls and Puts. Calls give the contract buyer the right to buy an asset, while Puts give the contract buyer the right to sell. Either way, the contract buyer will pay the contract seller a fee (known as the premium) to enter into the contract. Additional costs to the buyer can exist depending on other factors, but we can ignore them for clarity.

It is good to remember that generally, as secondary market instruments, the spreads on Options can be much smaller than the traditional assets on which they are based. Smaller spreads are one primary reason retail investors are attracted to trading Options.

Breaking down an Option with an example:

When Trader X sells a Put contract to Trader Z, Trader Z buys the right to sell an asset to Trader X before the contract expires. Whether Trader Z exercises this right mostly depends on the movement in the price of the asset.

Trader X will pocket the premium paid by Trader Z as compensation for offering the Option.

Trader X has sold the Put contract because they believe the price of the underlying asset will rise. In contrast, Trader Z thinks the asset price will fall. Thus, if Trader Z is correct, they will be able to sell the asset to Trader X at the agreed contract price (known as the Strike Price) rather than the asset's current value (Spot Price). Effectively, Trader Z will pocket the difference between the lower Spot Price of the asset and the higher Strike Price stated in the contract.

If Trader X is correct, Trader Z will not exercise their right to sell the asset at the contract's Strike Price, and the Option will expire unexercised.

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