CFD trading is different from stock trading. An investor buying shares is actually buying a part of the company, because stocks represent ownership. On the other hand, CFDs are about capitalizing on price movements without ever owning anything. CFD trading requires significantly lower capital, lets you use leverage and operates across multiple asset classes and global markets.
CFD trading vs stock trading is one of those questions every trader gets to at a certain point in their journey. In most cases, the choice depends on you rather than the instruments involved. If you’re a more dynamic person who trades regularly, wants to try your hand at multiple markets and asset classes, and has a higher appetite for risk, CFD trading might be a better fit.
But if you prefer to remain a passive investor who would prefer to see your wealth grow over time, then stock trading might be perfect for you. Both options are equally valid, but understanding how each of them works can help you make a more informed decision.
Understanding the Fundamentals
Stock Trading
A stock is a unit of ownership of a company. Owning a stock means that you own a small part of a firm. Over time, if the company does well, you benefit through price appreciation of your stock and any dividends that it pays out to its investors.
Owning shares also means you have the power to buy or sell stocks to others who are interested in doing so. The mechanism to do this is Stock trading, and it happens through regulated marketplaces called stock exchanges. In the US, the New York Stock Exchange is the major stock exchange where shares are listed for sale and purchase.
CFD Trading?
Contract for Difference, or rather, CFD trading, is a completely different process. You don’t actually own anything in CFD trading. Rather, you’re in a contract with your CFD broker to exchange the difference between the opening and closing price of an asset. That asset could be one of several different asset classes – shares, commodities, or even a pair of currencies.
Strictly speaking, the underlying asset hardly matters; what matters is whether the asset’s price goes up or down. When you enter a CFD contract, you don’t pay what is required to buy the underlying asset; you only pay for the value that the broker is willing to offer you for the contract.
How Does CFD Trading Work?
CFD trading works on the principle of leverage. You put up a small amount, let’s say $50, and borrow money from your broker to trade a CFD contract worth a much larger amount, let’s say $1,000.
A CFD contract will have a buy price and a sell price. The buy price is the current price of the underlying asset at the time you acquire it, whereas the sell price is what it reaches when you decide to give up the CFD. The difference between them is called the spread.
For example, if you buy a CFD for Apple when Apple is at $250 and then close your position when the same stock is at $260, the spread is $10. There are online tools that can help you calculate your profit and loss easily. After subtracting all costs, including spread costs to enter, you are left with your profit.
This is very different from traditional stock trading, where you have to actually put up the full price to first buy those shares, pay the brokerage and commissions for the transaction, and then again pay those fees when you decide to sell them.
Having this leverage is both an advantage and a disadvantage for CFDs, because while it makes your wins much bigger, it also means your losses are equally worse. This is why risk management is so important in CFD trading.
One important thing to note is that CFD trading involves multiple markets and financial instruments, and therefore, it is important to go with a reliable broker who provides you with a secure trading environment and can reliably handle the counterparty risk involved in trading these instruments.
What Are the Key Differences Between CFDs and Stocks?
Leverage
As explained, CFD trading allows you to benefit from price movements of assets even though you put up only a fraction of what they cost. Unlike CFD trading, traditional stock trading only works if you pay the full trade value for the share, and then hope for the stock price to move upward.
Leveraged trades give you a lot of power. You can amplify returns with less capital. But on the flip side, even a relatively small market move against you can completely wipe out all your gains. You can lose money you never had while trading CFDs, whereas something like that can never happen in stocks.
Short Selling in CFDs vs Stocks
CFDs let you potentially profit from falling markets as much as from rising ones. You can choose to buy a CFD or sell one without additional costs. That means that if you anticipate falling prices in an asset, you can short a CFD. You can profit on both rising and falling price movements, which gives enormous power to active traders willing to watch the markets closely.
The process of trading stocks without owning them is called short selling, and if you’re a stock investor on the New York Stock Exchange or London Stock Exchange, then you’re going to have to meet strict margin requirements to do it. The broker will ask you to put up a large portion of the value of the shares before you short-sell, as collateral in case the trade goes south. For most retail investors, margin trading is out of bounds.
Stock Ownership vs. Speculating on Price
Owning a stock is like buying into a story. You look at the company's reputation, its management, its financial performance, and then make a calculated decision to back the company's performance in the future, whatever the market conditions. You become an owner of part of the company, and want to see its stock prices move up.
CFD trading is all about price movements. While the prices may be moving due to fundamental factors, those factors themselves are not so important. Instead, you track market sentiment, watch the charts, and keep track of major market events that could influence the asset’s price in the short term. It’s best suited for active traders who are looking to get in and get out without caring much about the company’s story. It’s a huge mindset shift because it means CFD traders need to be quick on their feet all the time.
Market Access
Traditional share trading is often limited to a single time zone, a single type of asset class, and trading in a single time zone. If you want to trade in the stock market, forex, and commodities, you’ll have to open a separate account for each of them.
CFD trading is different. You can access a huge variety of asset classes and markets using a single trading platform.
Whether you’re interested in trading individual company shares, exchange-traded funds, commodities markets, foreign exchange instruments, or even cryptocurrencies, CFDs will allow you to do all of that. It lets you trade on global stock exchanges, effortlessly switch between different asset classes, and move money seamlessly between something as diverse as blue chip stocks and crypto currencies.
Tax Implications: Capital Gains vs. Trading Profits
In most countries, long-term investment in stock markets offers some benefits in capital gains tax. Investors pay less tax on investments that last for 5 years or more in many markets. This is because governments want to reward careful investing.
CFDs do not give you ownership of any underlying assets, so their treatment varies. In some regions, CFD losses are allowed to offset gains, whereas in others, tax authorities only consider the gains and not the losses. CFD traders should always get in touch with a competent tax professional to assess their liability.
Dividends
Dividends are a kind of cash bonus that the company pays to loyal investors when company performance is good. Stockholders usually get dividends deposited directly into their accounts. However, not all companies pay dividends.
CFDs aren’t a direct investment in the firm, rather just more of a leveraged bet.
Trading Costs: Spreads, Commissions, and Overnight Fees
Most brokers charge a per-trade commission for stock trading, which could be anything from 0 to $5-$10. There is no charge for holding the stocks as long as you want.
For CFD trading, brokers usually charge you based on your spread (the difference between buy and sell price). Tighter spreads mean lower charges. If the CFDs involve short selling, there are borrowing costs involved, which are charged on a daily basis. The longer you hold, the more you pay.
CFDs can be cheaper for short-term trading, but not for a long-term investment because those overnight fees tend to add up pretty quickly. That’s why active traders prefer CFDs over stocks.
Are CFDs Suitable for Beginners?
For active traders who have a good command of the basics, understand the risks involved, keep a close eye on market conditions, and are eager to benefit from price changes rather than holding the stock directly, CFD trading is a good option.
But what about those who are just starting out their trading journey?
The answer is simple - it depends on the person. Someone who is hungrier and willing to take higher risk, has the motivation to put in the hours necessary to understand the nuances of technical analysis, and is willing to mold strategy according to market conditions may find CFDs perfect for their needs.
Professional Traders: Which Do They Prefer?
Experienced traders trade both stocks and CFDs, but use them each for their unique strengths.
Share trading involves understanding industry trends and choosing stocks based on long term price rises that do not focus on the asset’s price on a day-to-day basis. They do not bother about investor sentiment or short-term trading risks. Experienced retail investors normally use this method for building wealth.
Large institutional investors like hedge funds and prop trading firms use CFDs mostly for short-term trading, speculation, hedging, and executing transactions that involve leverage. Unlike investing in stocks, using CFDs allows them to avoid the settlement complexities of multiple exchanges.
Which Approach is More Suitable For You?
For investors looking to build wealth slowly without taking too much risk, stock trading is optimal. Invest in blue chip stocks and index funds, follow company performance, and let price appreciation do the job for you.
Active traders who know how to benefit from an asset’s price movements, want to trade across global stocks and multiple asset classes, and understand how to manage risk should opt for CFD trading.
Finding Your Trading Groove
To be honest, the choice between CFD trading vs stock trading depends more on the investor than anything else. They’re two ways to approach wealth building in financial markets, and both serve different investment objectives and risk management skills.
CFD trading is best for active traders who want to benefit from price movements in short-term trades, while traditional share investing is better suited for those who prefer the less riskier method of long-term investment in stock markets or who want to be largely "hands-off".
