There’s more than one way to gain exposure in and profit from the stock market. Investing in stocks as the primary asset is one, and trading contract for differences or CFDs is another. Stock trading and stock CFD trading each come with their own sets of risks and rewards and are suitable for different kinds of traders.
Stocks and Stock CFDs: What’s the Difference?
Having a working knowledge of stocks is the first step to understanding CFDs. You observe the same market which means you can use the same analytical tools such as stock volatility calculators. The difference between stocks and stock CFDs is ownership. When you buy a stock, you effectively own a share of that company that you can sell later on.
A CFD, on the other hand, is a financial derivative that doesn’t give you ownership of the primary security. Instead, what you buy is a contract between you and another party — generally a broker — based on a prediction you make of the stock’s price movements, which can go either way.
Typically, stock investors buy shares they think will appreciate in value, which is also known as going long. But, say you think the stock prices of company ABC will decline. As a stock trader, you would want to opt out of buying ABC stocks to avoid suffering a loss. Or, you can short ABC stocks you already own (more on that later). A stock CFD trader has the option to bet on said decline and net a profit from the price difference in the value of the stock. And because you don’t actually own the underlying asset, you don’t risk losing to the negative price movement.
Advantages and Disadvantages
Shorting: Traders have the option to go for a long or short sell. The first simply means you purchase stocks now to sell it for a higher price later on. It’s a common strategy for long-term or passive investing. The process of short selling stocks is a little bit more complicated — you’re essentially borrowing overvalued shares to sell and buying it back later at a much later rate. Taking the short position is much simpler for stock CFDs as seen from the ABC company example. The steps are similar to taking the long position and easier to understand and visualize, except your prediction of the stock value is the opposite.
Leverage: Stock CFDs can be traded on margin, or using leverage from a broker. These are borrowed funds to increase your exposure to the market that can allow you to multiply profits and enter other trades using limited capital. However, leverage also risks magnified losses. In contrast, stock trades require upfront payment so you don’t risk losing more than you started with.
Costs: Stock trading fees such as brokerage fees and trade commissions can eat into your returns. While those are also true for CFDs, trading stock CFDs are exempt from stamp duty in the UK and Ireland. This allows traders to save on 0.5% tax rate on owning securities, which doesn’t apply to owning financial derivatives like CFDs.
No ownership: Not having ownership to the asset means you aren’t exposed to the risk of falling stock prices. The biggest drawback though is losing out on rights granted to shareholders of a company. These rights include sharing in the profitability as partial shareowners, influence to the decision-making process of the company, and voting.
Counterparty risk: Another major disadvantage of stock CFD trading is the heightened counterparty risk compared to stock trading. This is because you’re dealing in derivatives instead of the primary security. A CFD provider can default or fail to deliver on their promise to you resulting in lost capital. That’s why being selective with a broker is a must as there are some unregulated providers.
Which one should you trade?
Stocks and stock CFDs each carry their own set of risks and rewards. Though stock trading is by no means easy, it doesn't require as much experience as stock CFD trading. Share trading also grants investors certain rights that CFD traders don’t get. And you can take a long-term and passive approach to stock trading.
With that said, stock CFD trading is unique in that you can actually profit from falling share prices. Leverage can magnify your profits on a limited trading capital and you can enjoy lower fees. Stock CFDs are more suitable for active traders and short-term investing.