Stocks vs Stock CFDs
Reading time: 5 minutes
CFD trading mimics share trading with the exception that in a contract for difference, you actually don't own the underlying asset, unlike company shares, where you do. This is what we call the CFD stock market for trading, and it is definitely a great stocks trading alternative.
What you are essentially doing with CFD trading is buying a contract between yourself and the CFD provider that, depending on your position as (either 'Short Sell' or 'Buy'), will have an entry price when entering a trade, and an exit price when clearing out your trade with an equal opposite position.
One of the key differences between trading a CFD long vs buying a security is that you can enjoy larger leverage features. Contracts for difference are traded on margin, meaning there is no need to tie up the full market value of purchasing the equivalent stock position. This also allows traders to open larger positions than their capital would otherwise allow, but having said this, there is also leveraged share trading available as well, where traders usually have lower leverage capability.
Stock CFD Leverage
CFDs are leveraged products; whereby traders trade stocks with leverage. Leveraged products enable traders to increase their exposure to an underlying asset with the leverage provided by their broker. When it comes to leverage stock trading, it is important to know that when a trade is opened, you only need to deposit a percentage of the value of the position. We call this a margin. Your deposit will usually vary depending on the value of your CFD position.
Leverage might result in added gains should the market move in your favour. But there is also a risk of increased losses if the position moves against you, and trading is performed on stock CFD such as the MetaTrader 4 (MT4) and MetaTrader 5 (MT5) platforms. It is highly recommended to exercise risk management during CFD trading, to make sure you are aware of the risks involved, and are managing them accordingly.
There are also a number of key differences between trading an underlying asset and a CFD:
- CFDs stocks can be traded long or short, and you are not required to deliver the underlying asset in the event of a short sale
- CFDs are exempt from the UK stamp duty of 0.5%, although profits are subject to capital gains tax
- The investor doesn't own the underlying asset over which the CFD is based, but instead enters a contractual agreement with the CFD broker, to exchange the cash difference in the price between the opening and closing prices of the contract
- As opposed to holding the underlying asset, a CFD is traded on margin which means that an initial deposit is lodged with the CFD broker, which allows the investor to buy or sell a number of CFDs according to margin computations, which generally allow extra leverage over the stock purchase itself
As a rule, one CFD will be equivalent to one share, except that with contracts for difference, your broker will normally require you to put down a small percentage in the range of 5% to 25% of the total contract value. For example, a share CFD with a stock CFD margin of 5% can gain you an exposure of up to twenty times in comparison to the equivalent deposit capital if invested directly into shares.
Let's assume you buy five shares in Google Corporation at $400, thus, you would outlay a total of $2,000 ($400 x 5). However, if you bought five Google CFDs at $400, and the margin requirement was 5%, you would only be required to outlay $100, thus leaving you with more money to utilise on other trades.
The net effect is a return (or loss) of 20 times the amount using CFDs in comparison to direct shares, as a result of the leverage factor. Having said that, as CFDs are traded on margin, this means that your broker is effectively lending you funds, and it implies that a CFD trade attracts finance charges if a position is held overnight.
Owning physical shares by comparison does not attract a finance charge, as you are utilising your own capital. Normally, the interest is charged on the full market value of the CFD position, with the rate set by your CFD provider.
Naturally, the downside to geared trading is that you risk losing more than your initial outlay. You can also lose your entire investment if you buy physical shares, and the company becomes insolvent and is liquidated; however, you cannot lose more than your investment.
Lastly, and this is an important difference as compared with CFDs, generally you have additional rights when acquiring company shares (but be aware of the different types of shares), such as voting rights in the key decisions of the company.
For instance, if you trade a CFD on Microsoft or Volkswagen, you are in effect trading the price difference between your entry price and your exit price. As you do not own Microsoft or Volkswagen shares, you are only speculating on their price moving in a certain direction. CFDs concern only price movements, nothing else, and the contract is between you and your stock CFD broker.
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Please note: Tax treatment depends on your individual circumstances. Tax law can change or may differ in a jurisdiction other than the UK.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.