Futures, Contracts For Difference (CFD) and Daily Leverage Certificates (DLC) are different ways for investors and traders to gain exposure to price fluctuations of stocks, commodities and other asset types, without having to buy these assets outright.
Sometimes, owning the assets could be prohibitively expensive or impractical. After all, do you want to hire a security guard to watch over your gold bars? Where would you like to store your barrels of crude oil?
We’ll examine the similarities and differences between them, so you can decide which tool suits your purposes best.
What CFDs, DLCs And Futures Have In Common
In essence, CFDs, DLCs, and Futures are contracts to buy or sell an underlying asset at a specific price, in a future point in time. Their main similarities can be summarised as follows: 1) Allow you to speculate on price movement of underlying assets, 2) Implicit leverage element built-in.
With these contracts, you can speculate on price movement of underlying assets in either direction (by taking long or short positions). If you think that an asset will go up in price, you take a long position by making a contract to buy the asset at when the contract expires. Conversely, if you believe the asset will fall in price, you take a short position, and make a contract to sell the asset when the contract expires.
In these contracts, there is also an implicit leverage element built-in. This means that you only need to pay a percentage of the value of the contract upfront. This is known as the margin, which can range from 0.5% (in the case of CFDs) to 50% (not uncommon for futures).
Because of leverage, if prices moves against you drastically, you could stand to lose a lot more than your capital. This is why they are considered high-risk investment instruments and are not suitable for passive investors or those who want to invest for the long term. Taking your eye off the market for even a day can be disastrous.
Futures are contracts in which a buyer commits to purchase a specified quantity of assets, or a seller to sell those assets at a pre-determined future date and price. Futures contracts are traded on exchanges (such as SGX), with contracts available for stocks, commodities, and currencies. Every futures contract will have the following components: Buyer, Seller, Price and Expiry.
Futures are listed Specified Investment Products, so investors need to complete the Customer Account Review (CAR) if you wish to trade futures contracts.
Read Also: Guide To Investing In Futures
Contracts For Difference (CFDs)
A Contracts For Difference (CFD) is a tradable contract between you (investor) and your CFD provider. When the contract expires, both parties exchange the difference between the opening and closing prices of the underlying asset, which can be stocks, currencies, commodities, indices or even cryptocurrency. Because CFDs mirror corporate actions, a CFD owner can receive a form of cash dividend and participate in stock splits.
CFDs are unlisted Specified Investment Products, so investors need to complete the Customer Knowledge Assessment (KRA) before they can open a CFD account and begin trading.
Futures vs Contracts For Difference (CFDs)
The main differences namely size, liquidity, and expiry.
In Singapore, futures are traded on the SGX derivatives market and typically come with large minimum contract sizes, and are mainly used by investment banks, institutional investors and professional traders. In contrast, CFDs come with much smaller contract sizes, suitable for even retail investors. Due to the fee structure, futures are more cost-effective for large trades compared to making an equivalent CFD purchase, which means futures are more cost-effective for those looking to make big traders.
Even though futures are bought and sold on exchanges, they are not as liquid, and may encounter slipped trade executions. For CFDs, the market maker is the broker, which guarantees liquidity in cases when opposing positions cannot be matched. The fact that futures are exchange-traded is valuable to professional investors, since prices are transparent. CFDs prices are given by the broker, with some brokers offering pretty large spreads.
Prices of futures contracts will converge near to the expiry of the contract, after which investors will need to make a new contract to continue to receive exposure, while CFDs do not expire and continue to mirror the price of the underlying asset.
Daily Leverage Certificates (DLCs)
Finally, we come to the DLCs, which debuted on the Singapore market less than a year ago. DLCs allow investors to gain magnified exposure to intra-day price movements of three indices: MSCI Singapore Index, Hang Seng Index and the Hang Seng China Enterprises Index. Investors can choose to take either a long or short position, and take on 3, 5 or 7 times of leverage.
This means that if the index moves by 1% from its closing price of the previous trading day, the value of the 3x DLC will move by 3%. DLCs are meant for short term trades, in particular, those settled within one day. At the expiry of the DLC, the final value of the DLC is calculated and automatically paid to investors.
Futures are listed Specified Investment Products, so investors need to complete the Customer Account Review (CAR) if you wish to trade DLCs.
What Makes DLCs Different From Futures and CFDs?
DLCs have two unique features that set them apart from Futures and CFDs: no margin calls and the Air Bag Mechanism.
Compared to futures and CFDs, there are no margin calls, so you will never lose more than your initial invested capital. The price of a DLC will be reset at the start of each trading day, based on the closing level of its reference index the day before. This means that every day, your gains or losses are locked in.
The Air Bag Mechanism in DLCs is designed to slow down the rate of loss during extreme market conditions. Every DLC you buy has a pre-determined air bag level, depending on the leverage ratio and the particular underlying index. Once this air bag level is hit, it triggers an intraday reset of the underlying index over 30 minutes. After the reset, the performance of the underlying index will continue to be tracked based on the new observed level. Obviously, with the air bag mechanism, you will also get reduced exposure in the event the index recovers after the Air Bag Mechanism is triggered, thus reducing your ability to recoup losses during a recovery.