A contract for difference commonly referred to as the CFD is a binding agreement between two parties that involves a buyer and a seller. When the two sign up for a CFD, the buyer agrees to pay the seller the price difference that would occur between the present asset value and its possible value at the time of the contract.
A key advantage with CFDs is that you do not have to own the underlying assets to be able to trade and earn profit from them. This is because the actual value of the asset is not very relevant to a CFD which operates more on the difference in prices between the entry and exit points. This arrangement is successful as the investor and the trading company forms a contract without using any stock, forex, commodity, or futures exchange. Over time, trading CFDs have become very popular because of the several advantages it offers.
Share trading and CFDs differ primarily because in share trading you must take full ownership of the shares while that is not necessary in the case of CFDs. You can make speculations on the potential price movements, without being in possession of the asset.
It is possible to trade CFDs using leverage. This means that you can begin trading and earning profit by investing only a small amount of funds rather than the entire asset value. This ‘margin’, helps you gain 100% exposure to the market. While this feature could help you magnify your gains, there is an equal chance of losing more than you invested as well. On the other hand, if you’re share trading the full amount required to open a position must be paid right away.
Difference between a CFD and a stock
As discussed above, the main differentiators between stocks and CFDs are the way leverage and ownership is used for both of them. When you buy a stock, you essentially own a certain amount of stake in the company whose shares you’ve bought by paying the entire price for it upfront. This is not the case with CFDs that allow you the liberty to trade various assets like stock, stock index, currency, commodity, or cryptocurrency without actually buying them.
Advantages of CFDs vs stocks
Traders can use leverage to open big positions with minimum available capital. As this would require them to borrow funds, it means that there’s an equal chance of making a big profit and a loss.
Go long and short
Opening long or short positions on CFDs is the same as in stocks. You simply click on “Buy” to purchase and “Sell” whenever you choose to depend upon your trading strategy.
Access lots of markets
You can trade CFDs on several top asset categories such as stocks, foreign stocks, Forex, Commodities, Indices, etc. In fact, if you’ve been wondering what is crypto trading, CFDs can offer a safer alternative to exploring the market.
CFDs can be traded round the clock and thus are a big hit with international traders. Do note that a majority of the stock CFDs can only be traded during the set hours for the stock exchange.
Is CFD riskier?
Leverage makes trading somewhat riskier. This happens because the market represents prices that are usually higher than what you have actually paid. Let’s understand this with an example. Suppose you paid just 10% as the collateral payment for a trade in the stock market, just a 10% fall in the stock price could make you lose the amount you paid upfront. You could always keep adding more funds to address margin calls but this requires a lot of caution. The risk here lies in the fact that there is a possibility of incurring more loss than what you deposited.
Is CFD trading cheaper?
Is it expensive to trade CFDs? Trading CFDs are often inclusive of the spread as well as an overnight funding charge. In some cases, there may even be a commission. When we compare this to stock trading , it includes the spread paid to the stock exchange, custody fees and even a commission sometimes. However, overnight charges are unlikely in stock trading. The commission-free aspect of trading has made it possible to draw a parallel between the cost of trading stocks and the cost of trading stock CFDs. However, this becomes relevant only when the duration for which the trade will be held is in question.
Trading CFD vs stock: example
Here’s an example:
You buy ABC stock with a bid: ask of $154.29/154.33
So when you buy 10 shares at $154.33, you pay $1,543.30
Another possibility is that you buy 10 CFDs at 154.33 and deposit a 10% margin of $154.33
To bear in mind here that a stock CFD generally represents a single share of the stock. However, with index CFDs, the CFD could even imply 10x the underlying asset.
With CFDs, it is much easier to take short positions with leverage and overnight holding costs in pictures. These meet short-term trading goals much more efficiently while stock trading can be more profitable in the long run.
Hedge stock position
A popular circumstance in which a trader will do both stock trading and CFD trading is hedging. This is typically where an investor wants to keep a long position in his stock portfolio open but wants to protect against short-term risk by going short the stock CFD. The lower margin requirement on the CFD implies that it is a more efficient hedge than going short.
Is it possible to simultaneously be involved in stock trading as well as CFD trading? If you’re going in for hedging, this is certainly possible. This can be very useful if you want to invest in a long position but the market appears particularly risky and hence you want to protect your funds. You can short a stock CFD to ensure that your investment is safe. Do remember that the lower margin requirement of the CFD typically results in a far better hedge as compared to choosing shorting stocks.