What are CFDs?
CFD stands for Contract for Difference. It is a contract between an investor and an investment bank or spread betting firm, usually in the short term. CFDs are financial derivative products that allow traders to speculate on short-term price movements. When the contract ends, both parties exchange the difference between the opening and closing prices of a specified financial instrument, which can include forex, shares, and commodities.
At the end of the contract, the parties exchange the difference between the opening and closing prices of a specified financial instrument, which can include forex, shares, and commodities. Trading CFDs means that you can either make a profit or loss, depending on which direction your chosen asset moves.
CFDs are especially popular within the forex and commodities trader community. Since CFDs are derivative, the traders do not own the underlying asset. The only exposure they face is the change in price movements of the underlying asset.
How do CFDs work?
CFD trading allows investors to buy or sell a number of units in a financial instrument that is linked to an underlying asset, rather than the asset itself. CFD providers typically offer exposure to a range of global markets including currency pairs, stock indices, commodities, and shares.
In CFD trading traders have to choose the number of contracts they are willing to purchase. If the price of the underlying asset moves in favor of the trader, they are likely to earn a profit. If the price moves against the trader’s position, the trader is likely to incur a loss. Profits or losses are realized when a position is closed and the contracts that had been bought at the outset of the bet are sold
Let’s consider an example to better understand CFDs trading.
An investor X buys 100 share CFDs at 500p and then sells them at 550p. In this instance, the gain would be £50.
However, if the CFDs were sold at 450p the loss would be £50.
What are the costs of CFD trading?
There are three basic ways that CFD traders are charged.
- Spread, which is the difference between the ‘bid’ and ‘ask’ prices. For a trader to make a move in its trade, there should be a positive change in this spread. These spreads are not usually high
- While some trading platforms will advertise commission-free CFDs trade, they might impose wider spreads. Therefore, it is important to consider the overall fee package before choosing a provider. A commission charge is also quite common, usually a fraction of a percent of the value of the underlying security when a position is being traded out. Separate commissions may not be charged where indices, rather than individual securities, are being traded.
- CFDs usually levy a daily interest charge whenever a position is held overnight, and this is usually applied at a previously agreed rate. The interest rate is usually decided upon at the start
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What are the risks of CFDs?
CFDs are highly leveraged over-the-counter derivatives. Traders can lose more than their initial deposit and the potential losses may be unlimited.
Leverage
CFDs are leveraged products. Leverage gives traders exposure to the markets by depositing just a percentage of the full value. This means that while traders can also earn a potential profit if the market moves in their favor, they could just as easily make significant losses if the trade moves against them, making it a risky investment.
Risks of Over-trading
CFDs are a lower-cost way to access the markets because the capital commitment on each trade is lower than it would be investing through non-margined means. Therefore, traders can quickly slip into the tendency to over-trade.
Over-trading is where a portfolio is too exposed to the markets at any given time. And the remaining capital is not sufficient to cover losses across the portfolio.
Market volatility and gapping
Market volatility is very common and completely unpredictable. Gapping is a risk that arises as a result of market volatility. Gapping occurs when the prices of the instruments suddenly shift by a good amount. And the trader might not have the opportunity to execute a trade during this sudden shift in price.
Rigid Margin Requirements
Margin requirements are one of the risks on the technical front for CFDs. The margin portions of CFD transactions are set by the broker, who decides what percentage of margin the trader is required to stump up for access to a given market. This varies across different markets and amongst different brokers. This margin requirement serves as a restriction on the freedom of investment.
Lack of Ownership
CFD trading is not like purchasing stock from the market directly. There is no underlying ownership of anything other than the contract itself. This lack of ownership makes CFDs a less robust investment prospect.
Cost of Overnight Financing
CFDs are so highly leveraged, therefore the shorter the term the better. Overnight financing costs are applied on a daily basis for every trading day that a trader maintains an open position. These costs can quickly mount up if the contract is held for a longer period like weeks or months.
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Benefits of CFDs
No stamp duty
There is no stamp duty to pay on a CFD trade as there is physical ownership of the underlying asset.
Trade on both rising and falling markets
With CFDs, trades can trade during both market trends: when the price of the product is going up or down. This way traders can try to benefit from both market movements. Many investors use CFDs as a way of hedging their existing portfolios through periods of short-term volatility.
Efficient use of capital
One of the key advantages of CFD trading is that traders can trade on margin, which gives them ‘leverage’. This means they can trade without having to invest the full value of the underlying asset. This way their money is not tied up and is available for other investments.
Invest in a wide range of markets
Traders can easily access CFDs for Forex, shares, bonds, indices, commodities, ETFs, and more – all from a single account.
Technology provides some worthwhile assistance
There are a host of automated trading tools that can be utilized when CFD trading. You can use AI to enter and exit trades on your behalf, as well as to help with market insights and more.
What is Stock Trading?
Stock trading involves buying and selling shares in a certain company. If you own certain stocks and shares of a company, it translates to you owning a piece of the firm. Stock trading means buying and selling shares in companies to try to make money on price changes. Traders watch the short-term price changes of these stocks closely. They try to buy low and sell high.
Types of Stock Trading
There are two types of stock trading:
- Active trading is when an investor executes multiple trades in a month. They often use strategies that rely heavily on timing the market. They try to take advantage of short-term events to earn a profit.
- Day trading is buying and selling the same stock in a single trading day. Day traders aim to make a small amount of profit with every trade based on daily price swings.
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How to Trade Stocks?
- Open a brokerage account
Stock trading requires having a brokerage account. That’s a type of account designed to hold investments. If you don’t already have an account, you can open one with an online broker in a few minutes.
- Set a trading budget
Having a budget for investment in a particular category is very important. Always remember:
- Invest only the amount of money you can afford to lose.
- Don’t use money that you will be needing in near-term, for important expenses like a down payment or tuition.
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- Learn to use market orders and limit orders
There are several options for order types, the most common are:
- Market order: Buys or sells the stock at the best available price.
- Limit order: Buys or sells the stock only at or better than the set. For a buy order, the limit price will be the most you are willing to pay. The order will go through only if the stock’s price falls to or below that amount.
Stock Trading Risks
There are some risks involved in a better understanding of the stock market. These types of risks are as follows:
- Volatility – Volatility refers to the price fluctuation of a stock or security over a period of a year. Not just the stock itself but also the market may be affected by volatility across the board.
- Inflation – The rising costs of goods and services can impact the future value of assets such that income may be reduced on account of less purchasing power. Inflation can cause volatility in the markets.
- Market risks – Stock prices can be very volatile and unpredictable subject to different market and economic factors both locally and internationally.
- Business risk: A listed company you invest in may suffer a severe decline in profits or even go bankrupt. This could be a result of many factors such as poor management, slowdown of the industry, and competition.
- Policy risk – Changes in government policies and regulations, also have a profound impact on the stocks and the market as a whole.
Strategies that prove beneficial for curbing these risks are:
- Diversification – Try to reduce risk by purchasing stocks belonging to different industries. Buying five or ten different stocks spread over different industries is a good idea. In addition to it, investing in ETFs or mutual funds also gives automatic diversification to the portfolio.
- Long-Term Investments – Long-term investment in stock is a smart investment move. This is particularly effective if the trader has invested in a good portfolio of stocks and they have invested for a long term like 10 years or more. As a result, they are bound to reap good returns from such investments.
- Do not leverage – Never purchase based on borrowing. Invest only a portion of the money in hand.
- Build your position slowly – Don’t jump in with all the money and start buying stocks. Take your time, do your research, and build up your portfolio over time.
- Don’t jump on trends – Market trends are good but not for everyone. Therefore, don’t try to trade every market trend otherwise you might lose more than the money invested.
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Benefits of Stock Trading
- Capital growth – One of the major advantages is an increase in the overall value of the stock portfolio. The price of a stock will go up or down over time. When it goes up, shareholders can choose to sell their shares at a profit.
- Dividend income – Many companies pay dividends to their shareholders. Dividends are an excellent source of tax-efficient income for investors.
- Voting privileges –Shareholders hold ownership in the company, hence the voting rights. The ability to vote means shareholders have some measure of control over who runs the company and how.
- Liquidity – Shares can be easily bought and sold than other investments meaning they are a highly liquid investment. This means investors can buy or sell their investments for cash with relative ease.
- Advantageous tax treatment – Dividend income and capital gains are taxed at a lower rate than employment income and interest income from bonds or GICs.
CFDs vs Stocks: Comparison
| Properties | CFDs | Stock trading |
| Ownership | No | Yes |
| Leverage | Yes | No |
| Go Long and Short | Yes | Yes (but going short is more complicated) |
| Range of markets to trade | Multiple markets | Equities and ETFs |
| Costs of trading | Spread & Rollover (Holding Costs) | Commission |
| Trading hours | 24 hours, 5 days a week | During Stock Exchange opening hours |
| Dividends | Yes via a cash adjustment | Yes |
| Losses | Losses can exceed deposits | Losses are capped at the amount invested |
| Voting rights | No | Yes |
The major differences between a stock and a CFD are leverage and ownership.
When you buy a stock you take ownership of the shares. Stock investing is in effect taking a small ownership stake in a company you believe in. When you buy a stock, you pay the full price for each share.
CFD on the other hand does not give ownership of the underlying asset. CFDs trade on leverage, meaning you can enter a trade with a smaller initial outlay of capital.
The next difference is the cost.
When trading CFDs, the cost includes the spread and an overnight funding charge, and sometimes a commission. Stock trading includes the spread paid to the stock exchange, custody fees, and sometimes a commission but never an overnight funding charge.
Commission-free trading has made the cost of trading stocks more comparable with the cost of trading stock CFDs in recent years. The main consideration of cost is the intended holding period for the trade.
The next difference is the ease of trading long and/or short term
CFDs tend to be preferred for day trading and short-term trading strategies. Because of the one-time cost of commission, stock trading is preferred for long-term investing.
Then comes the difference in exposure to multiple markets.
CFDs offer exposure to a wide range of financial markets such as equities, forex, commodities, etc.
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CFDs vs Stocks Trading: Similarities
- Exposure to share price: Both CFDs and stock trading allow traders to speculate on stock market movements.
- Risk: The risk of losing the principal amount invested is there in both CFDs and stock trading. Therefore always do your research, remember that prices can go down as well as up, and never trade with more money than you can afford to lose.
- Liquidity: Both stock and CFD trading are relatively liquid, meaning that both instruments are comparatively easy to buy and sell.
- Locations available: Both CFDs and share dealing are available to traders globally.
CFDs vs Stocks: Which is better?
When comparing CFDs vs shares dealing, both provide different ways of benefiting from price movements in financial markets and both can become a part of your portfolio. It is entirely up to the trader to decide which instrument is more appropriate for them.
With share dealing traders may apply a more both short-term and long-term trading strategy (for example, position trading) while with CFDs shorter-term strategies such as day trading are more common due to overnight fees.
Also if a trader is interested in gaining exposure to a broad range of financial instruments then CFDs are a better option. But if their aim is exposure to a limited amount of risk then stock trading is more suitable.
When deciding which instruments are best suited for your portfolio, remember to do your research, by studying the news and focusing on the fundamental and technical analysis. It is important to note that prices go up and down. Therefore, make sure to never invest more money than you can afford to lose.
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