Direct or Indirect Trading? Comparing Two Worlds
June 24, 2021
Direct or Indirect Trading? This is one of the key choices aspiring traders must make. It's a decision that presents complex elements, given the many opportunities both alternatives offer. The first step in making a well-informed choice is to gather information, of course.
This article aims to provide the fundamentals of direct and indirect trading, creating the best conditions for a serious, rational evaluation.
In the first part of the article, we will provide concise definitions of indirect and direct trading. In the second, we will discuss the pros and cons of both alternatives. Finally, we will summarize the discussion, offering additional insights for an effective choice aligned with your needs.
What is Direct Trading and Indirect Trading?
Direct trading refers to trading conducted using the actual assets themselves. It contrasts with indirect trading, which is trading conducted using derivative instruments that utilize the assets as underliers.
It's straightforward to explain and understand the fundamentals of direct trading, as they are the same as commerce in all its forms. The goal is to sell the product at a higher price than the purchase price, generating a surplus, which represents the actual profit. The "trick" lies in accurately estimating the future price to make the best choices regarding timing (entry and exit from the market) and assets.
Some asset classes lend themselves more to this mechanism, as they are characterized by strong and frequent fluctuations. Generally, we can consider cryptocurrencies the most volatile assets, followed by stocks and commodities.
To understand the fundamental mechanisms of indirect trading, it is necessary to have a clear idea of the concept of a derivative instrument. Essentially, it is a standalone asset, often a contract, whose potential value depends on the prices established by the counterparties and the price movements of an underlier. Let's take the most widely used derivative product, the CFD (Contract For Difference): when a trader operates with a CFD, they establish (or accept) a price and determine an expiration. When that expiration occurs, they profit from the difference between the established/accepted price and the actual price.
There are various derivative products, some governed by different mechanisms. The reference, among others, is to ETFs. These are managed savings funds whose purpose is to replicate the performance of an underlier. The manager, rather than "risking" and aiming for the maximum possible gain, operates so that the fund's returns correspond to the price fluctuations of the underlier.
In turn, ETFs can be transformed into assets and traded in "direct mode". Or, more precisely, it is possible to do so with the fund's shares. Specifically, they are bought and sold to generate a surplus.
However, the most common type of derivative product is CFDs. There is an even older and more institutional version of CFDs. It is called a Future. Futures are issued by institutional entities, unlike CFDs which are issued by brokers. As a result, CFDs are much more numerous than Futures. In terms of security guarantees, however, there are no significant differences between the two products.
Pros and Cons of Direct Trading
Let's now analyze the pros and cons of the two methods. Let's start with direct trading.
The biggest advantage of direct trading lies in its fundamental simplicity. To be clear, it doesn't mean it's easy to make money, but rather that the mechanisms are understandable and accessible to everyone. It's about "buying low" and "selling high".
The other advantage relates to specific asset classes, those whose ownership generates returns. Consider stocks: those who own stocks for a certain period can benefit from corporate dividends. This advantage is precluded in indirect trading, which does not involve asset ownership.
Regarding disadvantages, it should be noted that it is impossible to trade certain asset classes. For example, those that do not refer to a "real" asset. The reference is to indices. In theory, price fluctuations, or rather value fluctuations, could guarantee profits. However, direct trading cannot be practiced on them as it is literally impossible to own an index. They can, however, be used as underliers and traded using the indirect method.
The same applies to assets that can theoretically be owned but are not compatible with a concept of real ownership in practice. Consider assets that require logistical effort. Essentially, all commodities. Well, trading commodities, at least at a retail level, means trading indirectly, i.e., through derivative products (CFDs, Futures, ETFs, etc.).
Another advantage relates to costs and times. Moving a real asset, compared to "entering into" a Future or CFD, is more demanding. Hence, slightly longer transaction times and higher costs. Often, fixed commissions must be paid, which risk eroding profits.
Pros and Cons of Indirect Trading
The pros and cons of indirect trading are essentially the mirror image of those of direct trading.
The biggest advantage is the ability to trade asset classes that normally preclude the possibility of trading. We have already provided ample examples in the previous paragraph: indices, commodities, etc.
Another advantage is the possibility of profiting even when the trend is downward. The derivation mechanism provides this opportunity, as it allows the moments of purchase and sale to be inverted.
Another advantage, which has its roots in technical (and even technological) dynamics, concerns financial leverage. Basically, trading with CFDs and Futures allows for the use of slightly higher leverage, precisely because real assets are not being moved, but simply exploiting their price movements.
A final advantage relates to times and costs, which are both reduced. The issue of timing is fundamental, especially in certain areas. For example, trading with cryptocurrency CFDs is much more convenient and faster than trading with real cryptocurrencies (buying and selling them).
Regarding costs, it should be specified that generally commissions are mild. In some cases, they are completely abolished. In particular, the economic model of Brokers is based on the concept of the spread, i.e., the difference between the price imposed on the trader and the actual price. Obviously, spreads are clearly stated. It is a model that satisfies everyone. It allows the Broker to profit on one hand and differentiate itself from competitors on the other (e.g., by offering competitive spreads); it allows the trader to profit without fearing that their results will be compromised or even nullified by commissions.
Regarding disadvantages, the inability to enjoy any benefits determined by real ownership should be mentioned. The clearest example, which we discussed in the previous paragraph, concerns stocks. If you trade with CFDs or Futures on stocks, under no circumstances can you obtain dividends.
Finally, there is a disadvantage, which, however, is a symptom of an overall flourishing context. Some classes of derivative products are present in... perhaps excessive quantities. The supply of CFDs is indeed extraordinary, both in terms of Brokers offering related services for trading them and in terms of underliers. This can cause disorientation for the novice trader and lead them to make hasty or wrong choices.
A Conclusion
So, what to choose between direct and indirect trading? As always happens with this kind of "choice", it is not possible to provide a univocal answer that suits everyone. After all, the characteristics of both alternatives are extremely varied, and both offer good opportunities. The advice is to explore thoroughly and reason not in light of an ideal of perfection, but of your own characteristics as a trader.
Exploring thoroughly also means practicing with both alternatives. Basically, a risky approach. Fortunately, Brokers provide demo accounts with which it is possible to simulate real market operations without risking anything.
Finally, a clarification. It is certainly necessary to decide between direct and indirect trading. However, this decision-making process should not be understood in an exclusive way. In fact, the two alternatives do not necessarily exclude each other. On the contrary, in a diversification perspective, they can - must - both be practiced. The decision should focus, rather, on the trading method.
