Share Trading - CFD Trading - Option Trading

When it comes to trading leveraged financial instruments, there are a number of alternatives out there to choose from. I’m about to share with you my thoughts comparing the two most popular of these alternatives - Option Trading and CFD Trading. By the time you’ve finished reading, you will hopefully be forewarned of some of the advantages and traps, based on my personal experience, successes and failures.

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I started option trading about five years ago after attending one of Nik Halik’s seminars. My initial approach to the markets was based on a very directional approach. If I expected the share price to rise or fall and I got it right, I made money. If it didn’t go the way I expected, I lost money... simple as that.

As time went on and I gained a deeper insight into how the options market works, it occurred to me that even when I get it wrong, more often than not, I can adjust my position so that I usually don’t lose any money and can even make a profit. The one beautiful word that comes to mind when I think of option trading, is "flexibility".

Consider this example: You’re looking at a chart of a stock that you’ve observed has been channelling between a high and low point over recent months (or even days). It’s an upward sloping channel, which means that over the long term, the stock is trending upwards. You see it come to the bottom of the channel and believe the odds are in your favour, that it will rise up again. But when it hits the bottom of the channel, it does so with a decisive downward thrust. This would normally be good reason for "out of the money" call options to be under-priced, as the market is more focussed on the stock falling, which makes put options more popular.

So you purchase some "out of the money" call option contracts very cheaply. I think they call this "the contrarian approach" - do what everyone else is not doing. From now on, one of three things can happen:

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(1) The stock can bounce up again, as anticipated.

(2) The stock can go sideways for a short time before deciding on future direction.

(3) The stock can break through the channel and continue to fall.

Let’s examine the consequences of these alternatives:

(1) The stock bounces. Because you’ve purchased your call options cheaply, you’ll make an absolute killing - often at least 100% on your investment. You’re laughing!

(2) The stock goes sideways. If you’ve purchased options with plenty of time to expiry, meaning at least 45 days, you can just wait until the market shows you which way it’s going to move.

(3) The stock breaks down and falls. Here is where the beauty of option flexibility comes into play. If the stock breaks down, a sell-off will usually follow. So what do you do now? You keep your call option and also purchase the same amount of "out of the money" put options. If the price falls just a few days, you’ll make a handsome profit - and this profit will pay for the losses on your call options. Once you’ve reached a breakeven point, you sell your put option. All you need now, is a short retracement in the share price and you can make a small profit on your call options. But even if it doesn’t, you haven’ lost any money and that’s a good thing.

Now let’s take the same scenario, but this time you’re a CFD trader. At the bottom of the channel, you probably wouldn’t dare to go long, in case the price continued to fall. So you would have to wait until the market showed you a clear signal to enter, either long or short. When trading CFDs, I have so often found myself in a situation where, although my anticipation of future market direction was correct, I have been stopped out by intraday movements before the share price could get there. This is because CFDs are highly leveraged instruments, usually around 95% of the overall investment is financed by the market maker. This means that a move against you is magnified 20 times. If the market makes a sudden large move against you, you're exposed to unlimited risk and can lose most of your trading capital whereas with option trading, the most you can lose is the amount of one investment.

CFDs often appear more attractive because they are far more liquid (easy to buy and sell) and there are many more stocks, currencies and commodities you can trade them over, all around the world and with ease, using only one market maker. But they are also very directionally rigid. Once you’re in a position, you’re committed to that price direction. If you change direction, you usually lose money because you can only be committed to one direction at once. With options however, you can hold opposing positions at the same time and adjust your positions until a profit, or at least breakeven, is realized.

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