Stocks and stock CFDs are complicated, especially when you have big money riding on a trade. This in-depth guide explores key differences between stocks and stock CFDs.
Understanding the differences between CFD trading and share trading can be difficult for beginners. But in this in-depth guide, we’ll explore what they are, and the other key details you need to know for well-informed trading.
CFD trading is similar to share trading, but in a CFD (contract for difference) you never take ownership of the underlying asset. This is something of a stark contrast to company shares, in which (as you may know) you actually secure ownership.
With CFD trading, you basically buy a contract between yourself and the party providing the CFD, that will have an entry price at the start of the trade and an exit price when you clear it out with an equal opposite position. Your choice of position — either a ‘Short Sell’ or Buy’ — affects the entry price.
A major difference between the trade of a CFD long and buying a security is the wider leverage features. As CFDs are traded on margin, there’s no requirement to tie up the total market value associated with the purchase of the equal stock position.
As a result, traders can open up bigger positions than their capital should accommodate. But it’s important to remember that there is an option providing traders with a lower leverage capability — leveraged share trading.
As CFDs are leveraged products, you’re trading stocks using leverage, and this allows traders to boost the amount of exposure to their underlying asset using leverage given by the broker.
It’s crucial to recognize, in leverage stock trading, that you need only deposit a percentage of the position’s value when the trade becomes open. This is known as a margin, and the deposit typically varies based on the CFD position’s value.
It’s important to know that the leverage itself can result in extra gains if the market goes on to move in a way which could be considered favourable for you. There is a clear danger, though, that losses could increase if the position actually moves out of your favour and trades are undertaken on stock CFD platforms (such as via MetaTrader 4 or MetaTrader 5).
As a result, it’s worth practicing careful risk management with CFD trading, especially when you’re still new to the process. This way, you’ll come to know which risks are involved and can take measured steps to manage them effectively over time.
Now, let’s look at the core differences between the process of trading an underlying asset and choosing a CFD.
While capital gains tax applies to profits from a CFD, CFDs are actually exempt from the 0.5 percent stamp duty in the United Kingdom
When trading CFD stocks, they can be traded short or long as you choose, and there’s no requirement to provide the underlying asset when a short sale occurs
CFDs are traded on margin: the CFD broker records the initial deposit, so the investor can choose to buy or sell multiple CFDs based on relevant margin computations, a process that can allow additional leverage over the purchase of stock itself
While investors don’t own underlying assets that CFDs are based on, they still enter into an agreement with the contract, bound by contract, that the cash difference in the entry and exit prices will be exchanged
Traditionally, a single CFD is equal to a single share, but with CDFs, the broker typically needs you to hand over a minor percentage of the contract’s overall value (between 5 and 25).
As an example, a share CFD carrying a stock CFD margin of 5 percent would gain exposure of as many as 20 times compared to the equal deposit capital if it were to be invested into shares directly.
So, let’s say you invested in Google shares at $400. This would amount to an outlay of $2,000 in total, but if you purchased five Google CFDs at $400 with a margin requirement set at 5 percent, you need just a $100 outlay. As a result, you would have more funds to channel into other trades down the line.
This creates a loss amounting to twenty times the value using CFDs compared to direct shares, due to the leverage involved. As CFDs undergo trading on margin, the broker is basically allowing you to borrow funds, which suggests a CFD trade position held overnight can attract charges.
However, taking ownership of physical shares attracts no financial charges, as you’re using personal capital instead. Traditionally, interest is charged at the CFD position’s total market value at a rate established by the provider.
There is a downside to this, though. With geared trading, you do face a danger of losing funds in excess of your original outlay amount. While buying physical shares means you can lose the overall investment if things go wrong, and the company may even go on to be liquidated in time, you can’t actually lose anything in excess of the investment.
Finally, let’s talk about the extra rights which come into force when you acquire company shares, including voting rights in the business’s major choices. For example, trading a CFD on a brand like Facebook, you’re essentially trading the price difference of the entry price versus the exit price.
As you don’t actually own Facebook shares, you’re just speculating that the price would move in a specific direction. CFDs relate to price movements only, nothing else, in a contract between yourself and the CFD broker you choose.
That brings this guide to a close. We hope you’ve found it valuable. Keep these details in mind when weighing up stocks and stock CFDs, to help you make the right decision.