Derivatives trading has become quite popular in recent years, with Contracts for Difference or CFDs emerging as the most widely used tool. The use of CFDs enables a trader to speculate on the rise or fall in the prices of fast moving financial markets, such as forex, stock indices, commodities and even treasuries. Another reason why CFDs are popular in the UK is that there is no stamp duty on them.
Another widely derivative instrument is an equity swap, wherein a set of future cash flows are agreed to be exchanged between two parties on predetermined dates in the future. Are these two types of derivatives the same? While both are derivative trades, they differ on several aspects.
This type of derivative trading means a trader does not actually buy or sell the underlying asset, whether a physical share, commodity or currency pair. Instead, what is traded is a number of units of a financial instrument, depending on one’s perception about the future movement of prices. For every point that the price of the instrument moves in the trader’s favour, a gain is recorded as per the number of CFD units bought or sold. Similarly, for every point the price of the instrument moves against the trader’s prediction, a loss is registered. What you should remember while trading CFDs are:
This type of derivative contract involves two counterparts exchanging cash flows over a regular period, but at least one of the cash flows has to be based on the performance of a stock or index. So, in case of an equity swap, one party pays the second the return or performance of a stock or a basket of stocks or an equity index. In return the other party pays a return, which is based on a fixed or floating interest rate, or another stock or index. Points to remember when dealing in equity swaps include:
Equity swaps enable an investor to participate in the performance of an equity index, without an initial investment or directly owning the stock. These swaps are formalized through a confirmation document.
So, both CFDs and equity swaps are derivative instruments that allow traders to participate and benefit from the ups and downs in the financial markets, without directly owning an instrument. The major point of difference between the two is that while the former can be used for varying kinds of assets, including stocks, currencies and commodities, the latter involves equity or equity indices only.
Another difference between the two types of instruments is that while CFDs have no fixed expiry date and positions are renewed at the close of each trading day or may be rolled forward indefinitely if there is adequate margin to support it, equity swaps are carried out for a fixed, pre-decided period.
If you liked this educational article please consult our Risk Disclosure Notice before starting to trade. Trading leveraged products involves a high level of risk. You may lose more than your invested capital.