CFDs vs Warrants, which is the best?

CFDs vs Warrants

Warrants have gained in popularity over the past decade, but are more and more challenged by CFDs and the growing offer in Switzerland. Both products offer leverage and the possibility to profit from rising and falling markets, yet they are inherently different. So what really sets them apart? And most importantly, which is best for you?

Markets available

For both the universe of products available is fairly large. You will find warrants and CFDs on Indices, currencies, bonds, commodities, rates, individual stocks, ETFs and more. Overall no big difference, although the CFD space is generally bigger with several thousand of instruments; so if you look to trade something specific for instance an exotic currency pair such as the Thai Bat or the Mexican Peso, CFDs is the place to go.

Advantage: CFD

Accessibility

A warrant gives you the right to buy (Call) or sell (Put) an underlying asset at a pre-defined price (strike price) until a specified time. The value of the warrant is mainly dependent on the underlying, but it is also affected by many other factors called the Greeks that include volatility, time to expiry, interest rate change etc… Additionally the fact that you need to choose a strike price and expiry may be confusing for the most inexperienced investors.

A CFD on the other hand is identical to its underlying and will move together on a tick by tick basis. The execution is also straight forward: if you think the market goes up you buy, if you think it goes down you sell. Your profit and loss is simply the difference between you entry and exit price. Clearly CFDs have an advantage in terms of simplicity and accessibility.

Advantage CFD

Risk management

With warrants your loss is capped to the amount invested. The worse that can happen is that your options expires worthless, and in this case you lose the premium. If the warrant does not move in your favour, you may still be able to sell before expiry at a positive value due to the time value.

The loss on CFDs on the other hand is not limited to the margin you put in. For example you buy 1000 shares of UBS at CHF 16 with margin of 5% of 800 CHF. Assume the price of UBS fall to CHF 15; in this case you have lost CHF 1000 which is higher than margin of CHF 800. You can however limit your losses with stop loss orders that will automatically liquidate your position when a defined level is breached. The difference is that if you stop level is reached you will no longer have a position, hence, you will not profit should the underlying subsequently move in your favour.

When trading CFD’s you are also subject to margin calls should the value of your portfolio fall below the minimum required level. In theory brokers will prevent clients to go below zero, although this is not guaranteed especially in case of extreme volatility.

Advantage warrant

 

 

Expiry date

Warrants have varying expiries ranging from days to years. The farther away, the more expensive is the warrant, as there is more chance it will end “in the money”. Choosing the right expiry is a critical component of successful warrant strategy. If too close, the warrant may not have enough time to generate a profit, and if too far, you may end up overpaying.

CFDs on the other hand generally have no expiry. You can therefore wait as long as you want for the CFD to come back in your favor, even if CFDs are rather used for short term trading due to the leverage.

Advantage: CFDs

Transparency & liquidity

CFDs are identical to their underlying, which makes it very easy for brokers to hedge the client’s positions directly on the market of the underlying such as the stock or the futures exchange. As a result the liquidity available on CFDs is the same as for the underlying market. Prices are also very transparent; for example take a CFD on Apple shares. The CFD will track the Apple share on a tick by tick basis. To verify an execution, one can refer to the underlying exchange, which is the NASDAQ for Apple.

The price of a warrant, on the other hand, is a combination of mathematical formulas and the margin of the issuer. The direct link with the underlying movement can be blurry to the investor. At times, clients can even wonder how the pricing is done. In addition, the liquidity can be scarce, during periods of important volatility.

Advantage: CFD

Leverage & financing

Both warrants and CFDs offer a leverage effect. The leverage on warrants is calculated by dividing the price of the underlying by the price of the warrant. For example a Roche shares trades at CHF 260 and a 3 month Call warrant cost CHF 15, the leverage is 260/15 = 17. That means you can buy 17 times more shares through the warrant, compared to buying the stock directly. For instance, with CHF 10000 to invest, you could buy 10000/260 = 38 shares versus 10000/15 = 666 shares through warrants.

The level of leverage has an inverse relationship with the price of the warrant.

For CFDs the leverage is set by the broker and remains fix. Assume the margin requirement for Roche shares is 5% which equals to 260*0.05= CHF 13 per share, then the leverage is 260/13 = 20 times.

For using a leverage you pay a financing cost on long position which is generally based on Libor majored by a commission from the broker. You would receive Libor minus the broker commission for short positions. For warrants the interest is factored in the formula used to calculate the price of the warrant.

Advantage: equal

Volatility

With losses caped and profits uncapped (for calls), the value of a warrant would benefit from a rising volatility. The opposite is true should the volatility go down. Many warrants traders actually trade the volatility of the underlying rather than the direction of a market. CFDs on the other hand can become a lot trickier in highly volatile markets. Stop losses get easily triggered and sharp portfolio moves either side can emotionally affect the trader’s decisions.

Advantage warrant

 

Conclusion

CFDs are more accessible, offer a wider range of products, and are more transparent compared to warrants. However, to be successful with CFDs requires self-discipline, complete risk awareness and precise money management processes, especially in volatile markets. Risk management is equally important for Warrants, yet easier to achieve as losses are capped to the premium invested. If you trade more based on intuition, then warrant’s imbedded risk management feature may suit you best. Both products aim at beating the market and, if successful, are able do so by the use of leverage and long/short strategies.