Derivatives trading is a mechanism in which traders are required to enter into an agreement wherein they will observe the market to understand the future value of the underlying asset of the derivate and then trade at a certain price or a future date. As the Contracts for Difference (CFDs) gained popularity, derivatives trading gained subsequent popularity as well. CFD is a tool that allows traders to speculate the price movement of fast-moving instruments or securities, like Forex, treasuries, stock indices, and other commodities. CFDs are more popular in the UK as these are exempted from stamp duty.
An equity swap is yet another popular derivative instrument. In this, two parties agree to exchange future cash flows on a future date that they fix in the present while finalizing the contract.
While CFDs and an equity swap are two widely used derivative instruments, they are poles apart from each other. Let’s discuss how these two tools differ.
What is CFD?
CFDs, contracts for difference, are derivatives products that allow traders to trade on live market prices without owning the trading instrument. In simple words, it is more like a contract than actual buying and selling of physical shares, currency pairs, or other commodities. A trader will inspect the market and make certain price speculations. Based on these speculations regarding the future price movement of the financial instruments, they will make a trade. The trader will buy a certain number of CFD units and will gain a point per movement in their favor. Similarly, they will also lose points if the price movement is against their speculations. All the gains and losses are registered in the trader’s account until the date set while buying the CFD units.
There are a number of things that you need to keep in mind while trading CFDs. Such as:
- Brokers offer leverages on CFDs. This means that you will need to invest a small amount to open a position with access to a larger operating capital that will be invested in the market.
- Both profits and losses can get magnified as you will be trading on margin.
- The difference between the buying and the selling price is known as a spread. Different brokers offer different spreads. Generally, tight spreads are preferred. You are required to pay for the spread to trade CFDs.
- There are holding costs that are levied on traders at the end of a trading day. Whether these are positive or negative will depend on the direction of the trader’s position.
- The best thing about CFDs is that these do not expire. You can carry forward or renew it at the end of a trading day.
- Just like in Forex, you can choose either a long or a short position. When you hold an open position before the company’s ex-dividend date, you receive a share of dividends as this position comes with a number of credits and charges. However, when you open a short position, and the CFD ends before the ex-dividend date of the company, you will be asked to pay the dividend to the company. Additionally, if you choose a long position, you are required to pay interest on your position for any overnight holdings.
What is an Equity Swap?
An equity swap contract is a derivative contract between two parties that involves the exchange of one stream (leg) of equity-based cash flows linked to the performance of a stock or an equity index with another stream (leg) of fixed-income cash flows. One party will pay the floating leg (typically linked to LIBOR). Then that party will receive the returns on a pre-agreed-upon index of stocks relative to the notional amount of the contract.
In order to understand the CFD equity swap difference, we need to explore what an equity swap stands for. In this derivative contract, there is a regular cash flow between two counterparts for a certain period of time. These cash flows are also known as the legs of the swap. One of the legs is pegged to a floating rate and is called the floating leg. The other leg depends on the performance of the stock(s) or the equity index. Therefore, it is called the equity leg. In this financial derivative, the investor can participate in the equity index performance even without directly investing or owning the stock. A confirmation document is used to formalize the swap.
There are a number of things that you need to keep when you are interested in an equity swap. Such as:
- There are various variations of equity but in every case, the equity leg has to be based on the performance of the stock(s) or the equity index.
- You can base the floating leg on a number of things like a foreign equity denomination, or even on a fixed or floating rate of interest.
- You can initiate the cash flow periodically or at the end of the contract. There is no set timeline for it.
Equity Swap vs CFD
Equity Swap and CFDs have a similarity in that the traders or investors who trade with them can benefit from the financial markets’ movement even without directly purchase assets, owning anything.
But there are a lot of differences between the two.
Equity Swap and CFDs are different because:
- CFDs can be used for a number of assets and equity swaps only to equity and indices
- CFDs do not have expiring time like equity swaps
The most important difference between CFD and swap is the option of tradable instruments. CFDs can be used for a number of assets like currencies, commodities, and stocks, equity swaps are also related to equity and indices. Another downside of an equity swap is that it comes with an expiry date. The two parties pre-decide the closing date of the contract. Such limitation is not applicable to CFDs. Investors can renew CFDs indefinitely at the end of each trading day if they see any scope of making further profits.