Because CFDs allow you to make a profit off a leveraged amount and to trade on margin, they have become popular trading tools despite the risks they carry. One of the main attractions is being able to enter elite financial markets without exhausting all of your capital on hand. Another type of derivative finding as much favour is an equity swap. This involves two parties agreeing in advance to swap a set of defined cash flows at a predetermined time. It’s easy to confuse these two types of derivatives, and while there are indeed overlaps, there are also some specific differences.
Grasping the notion of using leverage is essential to understanding how CFDs work. As a trader, you don’t need to come up with the cash for the full amount of the trade; you only need a fraction of it. You can make a profit in multiples of what you deposit, but you can also lose a lot more than you put down. Therefore, it should be obvious that you can also go long or short on a position.
As a CFD trader, one of the most important pieces of CFD advice is understanding that how you derive benefits and incur costs will depend on whether you’ve taken a long or short position. If you’re in a long position, you’ll have daily payment obligations but you’ll benefit in the form of a dividend from an underlying equity, such as a share. Conversely, if you have a short position, you will have dividend payment costs to give out. However, because of short-selling the underlying equity, you’ll receive daily interest payments.
When calculating expenditure and gains on CFDs, do not forget to take interest rate movements into account. They will fluctuate depending on what the market is doing, and how volatile an asset it can also play a role.
The fact that your choice of market is so vast is probably one of the most attractive aspects; you can choose from cryptocurrencies, commodities, shares and more. Technically, there’s no expiration date. You are free to renew and extend your CFD trades as long as you like. This sets it apart from futures or options, which come with a definite end date.
Equity swaps and their defining features
In an equity swap, you and another party exchange future cash flows (known as “legs”) over a set regular period. The difference is that there is no underlying security that determines the value. One leg is pegged against a floating rate; this is known as the “floating leg”. The other leg is based on the performance of a stock or market index. This floating vs. equity leg exchange is at the heart of a swap. For example, one leg could be based on a stock index while another is pegged to a foreign currency. They are also known as index return swaps. Cash flows are sometimes stipulated in advance, although they are normally exchanged at the end of a swap agreement.
If you structure an equity swap correctly, you can avoid paying capital gains tax.
Similarities between CFDs and equity swaps:
When you start to learn how to trade CFDs, it is important that you become familiar with the intricacies of a CFD versus an equity swap. Each of these is risky enough on its own, but if you get them confused, you could make a very regrettable mistake.
You can start trading CFDs with our partner broker eToro here