CFD trading on stocks allows you to day trade the equity markets. However, CFD trading on stocks is somewhat different compared to actual stock trading.
Many beginners can get confused between CFD trading on stocks and share trading.
These are two entirely different ways. Even the way these trades are made differ quite a bit. Many times, you can hear one say that they bought x shares in a company.
Would one infer that they bought the actual shares? Or have they merely bought the CFDs for those stocks?
As you can see, there are quite some differences between CFD trading and share trading, which we will point out in this guide.
To understand the differences, one should first learn how CFDs on stocks work.
Contracts for differences are derivatives of the underlying instrument. In the case of CFDs for stocks, these are the derivatives of the underlying stock.
Using CFDs one can easily trade them by speculating on the price direction. CFDs on stocks are available for trading by any online trading platform.
The most commonly used trading platform for CFD trading on stocks is of course the MT4 platform.
Although trading CFDs on stocks looks similar, there are quite some differences that can be seen.
The most important point to note is that trading CFDs on stocks and share trading are two completely different things. At the same time, there are quite some similarities between these two forms of trading.
Let’s take a look at how one would use share trading through an online broker.
How does shares trading work?
Trading in shares or stock trading firstly requires one to create a securities account.
This securities trading account can be opened through your bank or through a specialized retail stock brokerage. A typical shares trading broker may look similar to CFD trading on stocks.
For example, people usually think that trading shares on Robinhood is CFD trading. But this is not the case, as seen below.
Robinhood (@RobinhoodApp)
Securities brokers such as Robinhood are actual shares, trading brokers. This means that when you buy shares through such a platform, you are actually buying shares; not any derivatives such as CFDs.
When you buy shares through a stockbroker, your order is executed at the exchange.
These shares are then transferred to your securities account. In doing so, you have certain benefits such as:
- You have complete ownership of the shares you purchased
- The securities can also act as collateral to borrow from a bank
- Depending on the type of shares purchased, you can also have voting rights
- Capital gains tax laws are applicable
By executing your trades, the broker makes money by either adding a mark-up on the actual bid/ask and/or by charging an additional fee.
It is important to note that these days, you also have zero commission brokers.
These brokers make money through a markup as mentioned above or by routing your orders to a hedge fund or large institution.
With shares trading, obviously, you have only two choices. Buy the shares and sell the shares you own.
Short selling or the concept of going short does not work when trading shares directly.
How CFDs on stocks work?
As pointed out initially in this article, CFDs on stocks are derivatives.
Hence, the options available for you to trade these CFDs are more. First and foremost, derivatives are hedging instruments.
They are primarily used to hedge against the underlying security.
Thus, a trader who wishes to use derivatives would use it mostly to hedge against their original trade. This is sometimes referred to as insurance.
CFDs on stocks track the prices of the underlying instrument, which is the stock price.
Since CFD’s derive their prices from the underlying asset, you have the following benefits:
- Trade stock CFDs on leverage
- Go long and short on the CFD for stocks
- There are no capital gains taxes
CFDs on stocks can also be used as a speculative trading instrument.
In other words, to speculate on the price direction and make a quick profit, CFDs on stocks are ideal instruments to do so.
However, despite the additional benefits you get when trading CFDs on stocks, there are some drawbacks as well. These are:
- You do not own the underlying security
- The stock CFDs do not serve as collateral when seeking a loan
- You do not get any voting rights
The drawbacks as you can see are somewhat advantageous, especially for those who want to just take advantage of the volatility.
Many brokers offer stock trading on CFD. You can trade these instruments just as you would trade other assets like forex or indices or metals.
What should you know when trading CFDs on stocks?
When trading CFDs on stocks, it is clear that trading is a lot simpler than trading shares directly. However, there are some unique characteristics when trading CFDs on stocks.
CFDs on stocks are leveraged
CFDs by definition are leveraged instruments.
Typical leverage can be anywhere from 1:10 to 1:100. Thus, traders do not require large upfront capital to fund their CFD trading account.
This is one of the reasons why many retail traders prefer to trade stock CFDs rather than trade shares directly.
Using just a small portion of your capital, you can open a large number of shares through CFDs. But leverage can also be a disadvantage.
Because of the leverage you take, both profits and gains are also maximized. Many CFD traders do not give this much thought and have lost a significant amount of their capital this way.
This eventually led to regulators forcing brokers who offer CFDs to carry a disclaimer on the risks of trading with leverage.
CFDs on stocks attract financing costs
Because you are trading on leverage (i.e: purchasing through borrowing funds from your broker), there is an interest you have to pay.
This interest is called the overnight financing costs or rollover. The rollover is applicable if you have an open CFD position overnight.
The interest is charged on a daily basis and is deducted from your CFD trading account. The interest amount can vary from one broker to another.
Therefore, it is highly recommended that you check the symbol specifications to understand these overnight costs. The costs can vary depending on whether you are long or short on the instrument.
You can short stocks through CFDs
Through CFDs on stocks, it is easy for traders to take up short positions as well. This is one of the biggest advantages comparing to shares trading.
In shares trading, you can only sell the stocks that you own. There are instances where you can short sell.
But short selling requires borrowing shares from your broker (at a cost). You sell them and buy the shares back at a lower cost. You then return the shares that you bought, back to your broker.
Short selling in shares is often frowned upon and there are regulations governing short selling as well.
All of these complications can be avoided when shorting stocks through CFDs.
You just need to hit the sell button to take a short position in the market.
Stock CFD trading is not the same as investing
One of the biggest misconceptions in the trading world is the term investing.
When you are trading stocks through CFDs, you are trading them (i.e: opening a position and closing it after a limited period of time).
Some traders keep their positions open for a short period of time during the day. Others can swing trade and keep the position open over a few days at a row.
Still, this falls under the gambit of trading. Investing on the other hand (typically done through a securities account) focuses on buying and holding the shares for a longer period of time.
The average duration to invest in a stock is one year. Therefore, when you sell your shares within the year, it attracts higher capital gains.
Therefore, CFD trading on stocks is purely a short term trading instrument and is not ideal for investing. The reasons are clear because you will end up paying the overnight fees which are added every day.
When is it ideal to trade stock CFDs?
Trading stock CFDs are ideal under certain conditions.
Take for example the earnings season. During these quarterly earnings periods, companies announce their quarterly results and provide insights into the next quarter.
These earnings periods can be a quite volatile time for the shares in general.
Through stock CFD trading, traders can take advantage of these short term volatilities. Thus, you can open a long or a short position during such times.
The market volatility, combined with leverage you are using can result in quick profits.
This short term stock CFD trading strategy is not possible when trading shares. Obviously, the fees are detrimental, and profits are diminished after deducting the costs.
Example of CFD stock trading
Besides earnings, there are other events such as dividend payouts, which can cause intraday volatility.
Look at the chart below for IBM.
You can see the above IBM stock chart.
Price drops by $2.49 between the closing session and the next day’s opening session.
Through the leverage of 1:100, stock CFD traders could make a profit of $249 through an overnight trade. Even after accounting for mark ups and overnight fees, this CFD trade would net a decent profit.
With stock CFDs, the dividends are credited or debited to your account.
Thus, besides the overnight fees and mark up, the dividend amount would be deducted if you held a short position. Still, the profits outweigh the costs when trading CFDs on stocks.
Such a short term trade is not possible when trading shares. Firstly, if you own shares, you will have to liquidate the day before and purchase the same shares again the next day.
Besides earnings, dividends, company announcements are also good events that can increase the short term volatility in the market.
Traders can combine both the above fundamentals as well as technical analysis to spot such trading opportunities through CFD trading on stocks. Of course, the above example is a very simple one.
Is shares trading better than CFDs on stocks?
The obvious question that one would ask is whether shares trading is better than stock CFDs or vice versa.
If you read the above example given, CFD trading on stocks is not the same as shares trading. The concept of trading remains the same to both forms of trading.
However, shares trading is more suited for the long term investor. In this case, shares trading is ideal if you want to invest for the long term.
If you want to trade shares for the short term, then CFDs on stocks make for a better choice.
As illustrated in the above example, CFDs on stocks are cost-effective ways to trade shares. But at the same time, they are only suitable for short term trading or speculation.
Because of this advantage with CFDs on stocks, traders have to pay some extra fees.
With the shares trading, on the other hand, the product is designed for long term investing. Thus, although the initial costs may seem high, they are made up if you held on to the shares for a few years.
While there are clear benefits and disadvantages between shares trading and CFD trading on stocks, one aspect common to both is a risk.
Both shares and CFDs on shares are risky financial instruments. Therefore, you cannot expect to make money if you think you can just buy and hold the assets.
Shares or equities in general are risky assets. Therefore, depending on various factors these can impact your trading capital adversely. And this is regardless of whether you are trading shares or stocks on CFD.
Conclusion
To conclude, shares trading and CFDs on stocks are similar in the fact that they track the same asset class. However, when it comes to the order execution and the costs, CFDs on stocks and shares trading diverge quite a bit.
The reason behind this divergence is inherent in the way these instruments are designed. Shares trading is designed as an investment product, whereas CFDs on stocks are designed for hedging.
As a result, comparing both these instruments as one and the same is an ignorant mistake.
Due to the differences in these products, the way they behave and the characteristics they have also differ.
At the end of the day, the trader needs to understand their investing or trading goals. Furthermore, by assessing their risk tolerance, one can choose to trade shares or CFDs on stocks.
