CFDs, Binary Options, Digital Contracts, what’s the difference?

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If you are a trader who is new to the online trading scene you may be wandering what the difference is between all the retail instruments that you can trade.

What first started as simple Forex and Equity has now morphed into a massive industry with a number of different instruments that one can trade on including CFDs, Binary Options and a relatively new concept called the Digital contract.

Indeed, no one can blame the new trader for being slightly overwhelmed. The industry is constantly changing and it can be hard to keep track of the different ways individuals can make money in the retail trading market.

However, a little bit of research will no doubt help new traders make the most of these instruments? Given the unique nature of these products, they offer a number of different strategies that one can implement.

In this post, we will run through an overview of just how these instruments differ and what type of strategies one can implement.

CFDs

CFDs (or contracts for difference) are one of the oldest types of instruments on the market. Essentially, a CFD is a spread betting type instrument where the trader will get paid according to movements in the asset.

The trader does not own the underlying instrument but instead has entered into a contract with the broker at the entry price. The trader agrees that the broker can mark the CFD to market at the end of every day and roll the position forward every day.

Another important characteristic of CFDs is that they sometimes involve a large degree of leverage. In other words, the trader can enter a position that is considerably larger than the money that they stake on the trade. This is of course a double edged sword as the price can also go against the trader.

Hence, when trading CFDs, it is quite important that the trader makes use of stop losses that are well placed that can either realise the profit that the trader aims to achieve or can stop a loss when the trade goes in the other direction.

Binary Options

Binary Options are a relatively well known exotic option on Wall Street and have been used for a number of years. It was only in about 2008 that they were being offered on the retail market to average investors. One needs to understand the basics of binary options before they can start trading them.

A binary option is in essence a variant of a traditional financial option. It has the same characteristics, namely a strike, expiry time and price. The difference between a binary option and a CFD is that a binary option has a binary payoff. The trader can either get 1 (or 100) or 0.

This makes Binary Options a relatively straightforward type of instrument as the trader knows from the outset how much they are likely to gain or lose on the investment. It gives a certain degree of certainty for the investment which allows a range of binary option strategies to be employed.

In the case of simple High Low Binary Options, the investment is relatively straight forward and easy to enter. The trader either thinks that the price of the asset will go up or will go down. In the latter case he will enter a PUT option and in the former a CALL.

If the price goes up in the trade expiry time and the trader entered a CALL option then the option expires in the money and the trader gets the positive pay-out (100). If, on the other hand, it went the other way he will lose the initial investment. Of course the opposite can be said for the PUT.

This is why Binary Options are sometimes thought of as a “bet” on the direction of the asset. However, one should not assume that binary options should be traded as a type of casino bet as they are indeed an investment instrument which is priced uniquely.

Digital Contracts

These are a relatively new investment instrument that has been made available on the market. They are a combination of a binary Option and a CFD. They are essentially contracts where the trader can either enter a PUT or a CALL.

In its essence, a digital contract offers the trader the chance to enter a binary like trade with a number of different strike levels. It also offers the trader the chance to exit the trade prior to expiry and realise the profit.

These strike levels range from those that are close in the money (near current price) to deep out of the money (far away from strike). Hence, the range of payoffs that are available to the trader are quite diverse. The trader could make small gains on the instruments by entering contracts which are close to in the money. They could also make large gains on those contracts that are far out of the money.

This could work well for the trader that aims to make a profit from a large movement in the price on events such as price action moves on release of important economic news. The trader could enter contracts that are deep out of the money.

Conclusion

Although there are a range of instruments that one can enter on the retail market, each will serve a different purpose. It is important to make sure that you understand the risk and returns involved with each of these instruments.

A well thought out strategy will make use of a range of these instruments. This is possible these days given that most brokers provide a range of these instruments on their platforms.