ETFs versus CFDs

There are many ways and opportunities to trade and invest in financial markets. Traders and investors are constantly looking for the best option for them.

With all the trading possibilities available these days, it actually becomes difficult for traders to choose the most suitable option for them.

The aim of this article is to focus on two of the most popular trading options currently, namely Exchange traded funds (ETFs) and Contracts for difference (CFDs). By comparing the two financial instruments, their advantages and disadvantages will become evident, and hopefully, make it easier to choose the most suitable one.

When considering EFTs and CFDs, bear in mind that the selection of the most suitable trading option depends on the balance between investment returns and risk, your knack for investing, and your trading objectives.

What are ETFs?

An exchange traded fund, commonly known as ETF, is a type of investment fund that is traded on a stock exchange, therefore the name. ETFs are suitable to gain short term profits and also ideal as longer-term investments. They can be based on a variety of underlying asset types such as commodities, bonds, equities, indices, currencies, etc.

Although in simple terms just like mutual funds, ETFs should not be confused with mutual funds. They are actually traded like ordinary shares and subjected to price changes during a trading day as they are bought and sold.

Investors in ETFs share profits in the form of the dividends or interest earned from ETFs.

With ETFs, related underlying assets are combined together as a ‘basket’, and designed to track the performances of, inter alia, commodities, currencies, and indices.

What are CFDs?

A CFD (Contract for difference) is a tradable financial instrument which constitutes a contract between two parties to exchange the difference between the current price of an underlying financial instrument and its price when the contract expires.

CFDs can be traded with leverage, which enables traders to trade with small margins (deposits in their trading accounts).

As with an ETF, a trader never actually owns the underlying asset, like a commodity, currency, or a stock, and a profit or loss is determined by the difference between the buying and the selling price of the CFD, less any applicable fees.

As a trader you can either generate profits or incur losses when trading a CFD, regardless of the direction of the price movement of the underlying asset. For example, if your anticipation is that a certain commodity’s price will fall in the near future, then you can sell off the asset today. If the prediction has a favourable outcome, you will profit even in the midst of a falling price.

However, if the price moves in the opposite direction that you predicted, you will incur a loss.

In other words, you can incur losses and make profits when prices are rising or declining.

Comparison between ETFs and CFDs

• ETFs have been introduced much earlier to the financial world than CFDs. The first ETF was introduced in 1993, while CFDs hit the market during the late 1990s.
• Both CFDs and ETFs offer great trading opportunities. However, before investing in these financial instruments, take note of the following guidelines:
• sufficient measures for risk management have to be in place;
• understand your risk appetite;
• a good understanding and knowledge of the underlying asset(s) are required;
• familiarise yourself with the markets.
• CFDs provide opportunities for speculation and are usually utilized for short term investment strategies, whereas ETFs are mostly suitable for long-term investment.
• CFDs have high risk potential but also the possibility of high yields. Conversely, ETFs are safer investment instruments with smaller gains.
• Regarding ETFs, a trader is obliged to pay the full price of the underlying asset, while with CFDs, the trader is in agreement with the broker to pay the difference in price between the starting and closing dates of the contract.
• A CFD is a derivative, allowing a trader to make use of This means you have substantial gearing available for your trading. Typically, you will only have to pay a small percentage, for instance 5% to 10%, of the value of the underlying asset to trade. ETFs on the other hand are not leveraged as such and as a trader you have to pay the full price.
• Due to the advantage of leverage, CFDs enables you as a trader to generate profits on a much higher value of an underlying asset than you could buy with the same amount of money. ETFs do not have such an advantage.
• However, because of the leverage advantage, CFDs are a margined product and therefore, a trader is exposed to a margin call from his or her broker, if the value of the underlying asset drops. Your broker may request you to deposit more money to protect his own interests from you defaulting on your debt. There is no such a risk in ETF trading.
• CFDs have substantial interest charges for the duration of the contract because they are a margined product. ETFs are not subject to any interest charges.
• With ETFs a trader can never incur more losses than his or her initial investment. However, with CFDs, the use of leverage implies that both profits and losses will accumulate.