You may be weighing up whether to trade CFDs or to go with buying stocks in the traditional way. It’s fair to ask “why trade CFDs instead of stocks?” After all, isn’t there a lot of risk involved in buying CFDs? And isn’t it just easier to buy stocks?
Well in many ways these are valid concerns, but at the same time there are some advantages in buying CFDs, not least of which is needing less funds to open a trade with, but we will go into the pros and cons further below.
First, let’s take a look at the key differences between CFDs and buying stocks outright.
The Difference Between ‘Contracts for Difference’ (CFDs) and Stocks
CFDs are fairly new trading instruments and are offered through a variety of brokers. They are not available in every country but are a big part of the UK’s trading market.
Essentially with CFDs you are buying a contract from your broker for the future price of a financial instrument. Short and long CFDs have an entry and exit price, which means traders pay the price on entry and when they exit. So they make – or lose – money on the difference between the price of the contract at exit versus the price on entry. Unlike stocks, you don’t own the underlying asset of the CFD – it is classified as a derivative.
In contrast, investing in stocks means you have the ownership of the stocks until you sell them. So in essence ownership is the fundamental difference between CFDs and stocks, but there are also some nuances in how both operate which makes a significant difference to how they work in practice.
There are also quite a few pros and cons of trading in CFDs rather than buying and selling stocks in the traditional manner. Let’s have a look at these below.
Pros of Trading CFDs vs Stocks
Let’s take a look at the pros first:
Long and Short Positions
CFDs can be traded in both long and short positions. Short positions deliver a profit when the asset value drops. So you can potentially take advantage of financial instruments you think are overvalued and believe are likely to drop in price.
Traditional stocks can take days to settle. However, with CFDs you can open and close positions instantly. This also means that you have instant access to your capital which could potentially open up more trading opportunities and the ability to react quickly in certain situations.
Needing Less Funds to Enter Trades
One of the key advantages of CFDs is that you don’t need to deposit the full value of the asset to make a trade. So for example if you wanted to buy 1000 shares in a company in the traditional manner and they were priced at $2 per share, it would cost you $2,000 (plus fees).
However, with CFDs you are trading on leverage so would only need to deposit a fraction of that amount. In the UK at the moment, most brokers would allow you to buy the same number of shares for only $400 (meaning a 1:5 leverage), although the maximum leverage you can use varies by broker and by country.
Of course, the flip side is that there is also more risk to CFDs and it is crucial to ensure you have enough funds in your account to cover your position if the price moves sharply against you, but that is dealt with in more detail in the “cons” section below.
Reduced fees and commissions
Stock purchases are sometimes costlier and have a hefty broker’s commission (although these days you can get reduced commission fees by shopping around for a stock broker with low commission rates). CFDs tend to come with lower fees and broker charges overall though. Also most brokers won’t charge you to open and close positions. However you do have to pay interest on long positions, which is dealt with below.
Exemption from Stamp Duty
Traditional stocks and shares can incur a 0.5% stamp duty charge in the UK (depending on whether they settle through the UK electronic settlement system CREST). However, CFDs are exempted from stamp duty in the UK as they are not considered an asset.
Exposure to a broad range of assets
CFDs comprise a range of assets such as commodities, currencies, stocks and bonds giving you a broader choice then just buying and selling stocks in companies listed on the stock market.
Cons of Trading CFDs vs Stocks
However, CFDs come with their share of cons as well. We list a few below:
Interest on CFDs
You need to pay interest for holding long positions in CFDs. This is because in essence the broker has lent you money to make the investment. The interest is calculated on the CFD and deducted on a daily basis. The amount of interest is calculated using a formula involving the LIBOR rate plus normally around 2-3%. The interest fee is not charged if you close the CFD before 10 p.m. And if you hold a short position you actually receive the interest rather than pay it.
Risks of Using Leverage for CFDs
As you are using leverage to trade CFDs, you can end up losing a lot of money if a CFD drops below a certain point. A position you are holding might suddenly gap up or down against you and if you don’t have enough money in your account to cover the move, it will be closed out by your broker, leaving you with a hefty loss and without a chance to recover. This has probably happened to nearly every trader using CFDs at some point.
However, in the case of stocks the situation tends to be different. Stocks rarely drop to zero on the main markets such as the Dow Jones or FTSE 100 (although it does happen more often on smaller markets like AIM and with micro-cap shares). Stocks can recover after suffering a big dip, meaning if you’ve held the stock through the dip and it has recovered to its original position then you would not have actually lost anything. This is a major potential advantage of stocks over CFDs.
The key point if you are thinking of investing in CFDs is that you need to be aware you are trading on leverage and ensure you have enough money in your account to support you in case the trade goes against you. It is also a good idea to make use of stop losses where appropriate to reduce the risks of CFD trading.
Overtrading of CFDs
CFDs are very easy to trade. Therefore it is very easy to overtrade. This is one of the biggest mistakes traders make, particularly inexperienced ones. Traders should be patient and not open and close positions on a whim or without a clear strategy.
Conclusion – Why trade CFDs Instead of Stocks?
To summarise, CFDs are derivatives that involve buying or selling future contracts in various financial instruments including commodities, forex pairs, indices and shares. They do not confer ownership of the underlying asset.
CFDs present advantages over buying shares in the traditional way in that they allow you to go short on positions as well as long, provide quicker transactions, offer a broader range of financial instruments to trade and do not incur stamp duty in the UK.
However, CFDs also have disadvantages including incurring overnight interest (if going long), the risk of positions being closed if the market moves against you and the tendency of people to overtrade CFDs.
Most traders view CFDs as suitable for short-term trading where as stocks are often considered more suitable for long-term holdings. The main trade-off comes in the form of leverage, which gives you the chance to take a bigger position with a CFD compared to a stock for the same initial amount, but also carries more risk with it.
At the end of the day it is up to each trader to decide if they want to use CFDs or buy and sell shares in the traditional way – or do a mixture of both. Either way though it’s important to know the differences and the pros and cons so you don’t make mistakes and incur unnecessary losses.
Good luck with your trading whichever form you choose!
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