CFDs, or Contracts for Difference, are an alternative trading instrument that gives traders access to multiple asset classes, including stocks, forex, commodities, and even cryptocurrencies. In this post, we’ll go over the differences between trading CFDs on equities/stocks and trading the stocks themselves.
What exactly is a CFD?
It’s worth starting out by looking at exactly what you’re trading when you’re trading a CFD. Unlike stocks, bonds, and forex, CFDs are not an asset class. Instead, they’re actually trading instruments.
CFDs are OTC (over the counter) derivative contracts that are entered into between a trader and a broker or CFD provider. CFDs are very similar to futures contracts, though unlike futures, they’re priced at the current spot price. Futures, in comparison, are priced for a date in the future and can be traded on exchanges where CFDs cannot.
As the name implies, a CFD is a contract between two parties. One party agrees to pay the other the difference between the price of the underlying asset from when the contract is opened and when it is closed.
When a trader opens a new CFD trade on stocks, the broker opens an identical trade in the underlying stock, which acts as a hedge for the broker. For example, if the client has a long EUR/USD or gold CFD position, the broker owns the corresponding short position, as well as a long position in the stock.
What exactly is a stock?
A stock represents a share of the equity in a corporation. Stocks give their owners various rights, including:
- The right to a proportional share of dividends that are paid out.
- The right to information about the company.
- The right to vote at shareholder meetings.
- The right to a share of the assets if the company is liquidated.
As you can see, there is more to owning a share than merely participating in price appreciation.
Margin and Leverage
One of the key differences between CFDs and stocks is that CFDs are traded using margin, which means they come with leverage. This margin acts as a deposit and trading on margin essentially means the broker is lending capital to their client, thereby allowing them to trade with more capital than they have in their trading account. This means that both gains and losses are magnified.
Brokers that offer CFDs typically allow their clients exposure worth 5 to 50 times the value of the capital they actually commit to the trade. As an example, FXPRIMUS is a popular CFD broker which offers CFDs on over 50well-known equities. The margin on their equity trades varies between 5% and 30% of the value of the trade, depending on the volatility of the stock.
Traditional equity accounts do sometimes offer margin trading, yet this varies from broker to broker, is often limited to 50%, and often requires future collateral.
The other very compelling case for CFDs is the ease of short selling. Short selling stocks with a stock trading account are possible but this is often a tedious process. Whenever a short sale in an equity is executed, the stock has to be borrowed from a holder of the share, for which a fee is paid. The stock first has to be borrowed, before it can be sold. In many cases, borrowing stocks can be prohibitively expensive for retail traders due to the minimum amounts charged by lenders. Once the stock has been borrowed, traders are restricted in the way they can execute a short trade.
The entire process is far more straightforward with CFDs. Apart from a small number of stocks that can’t be short sold, from the trader’s perspective, there is little difference between going long or short. The entire process is built into the platform and happens behind the scenes.
CFD brokers are often able to match long and short positions from different clients off against one another, reducing borrowing costs in the process. CFD brokers can also borrow stocks at lower rates, making short positions more affordable for their clients.
Access to other asset classes
Traditional stock trading accounts allow clients to trade stocks and ETFs – which are a type of stock. You cannot use a stock trading account to trade forex, futures, commodities, indices or cryptocurrencies.
Most CFD trading platforms, however, give their clients access to several asset classes with one CFD trading account, usually forex pair like EUR/USD, GBP/ USD, etc. FXPRIMUS, for example, allows clients to trade 50 global equities, over 40 currency pairs, 3 energy contracts, 10 global indices, precious metals, and 7 major cryptocurrencies, all from one trading account.
The real advantage to this is that you can start out trading one asset class, and slowly begin to explore and add new asset classes over time.
Access to global equities
Traditionally, a stock trading account gives you access to the stock exchanges in the country in which the account is held. In most cases, though not all cases, you cannot use the UK- or US-based stockbroking accounts to trade equities in Hong Kong or Singapore.
We now live in a global world, and if you are going to trade equities you should be able to trade any company in the world. CFD brokers are able to easily add new exchanges and stocks to their platforms. Unlike normal stock accounts, clients do not need to have an account with each exchange. The CFD broker only needs one account to trade on each exchange and using that one account they can open CFD positions for all their clients.
As mentioned, stocks come with various rights. These rights do not come with CFDs. Since most traders are not interested in the underlying rights but in exposure to changes to a stock price, CFDs are a low-cost way to take advantage of price changes.
CFDs also offer a hassle-free method for traders to trade with margin, sell stocks short, and access other markets if they want. In short, while stocks are better suited to long-term investors, for day traders, swing traders and medium-term traders, CFDs are the way to go.
This article was originally posted on FX Empire
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