CFDs and traditional stock trading
When you are a traditional stock trader you buy or sell the underlying asset. You become its owner and then, you can sell it to another market participant.
If you are trading CFD, you will not own any shares in the company. You are buying or selling the contract instead. This contract for difference is negotiated between you and the CFDs provider. You speculate on the price of the underlying asset and try to predict its movement from the time you open a CFD up to the closing time.
And although the trading in itself is quite similar in both cases, there are some crucial differences between these two. What are they?
- A trader makes an agreement with his broker for the exchange of the cash difference in price from the opening and closing price at which the contract is concluded.
- Contracts for difference are traded on margin, which basically means that the broker is lending you money. This allows to use additional leverage and thus, opening a larger position than the trader’s capital.
- As in traditional trading, you can open buy or sell transactions. But in the case of sell trades, you are not obliged to deliver the underlying asset.
- The profit depends on the capital gains tax, but generally, they are relieved of a UK stamp duty of 0.5%.
How much money do you need?
Each broker brings its own rules so it may vary from one platform to another. But generally, we can assume that one contract for difference is equal to one share in traditional trading. Just here you will not need to have all the money in the account. Usually, you are only expected to bring 5% to 20% of the real value of the contract.
With just a 5% margin, you can achieve up to twenty times higher exposure than in the physical share market. If you, for example, buy 5 shares of the asset at $200, it would require from you to put down $1000. Yet, when you want to buy 5 CFDs at $200, and the margin is 10%, you will have to give just $100. And the rest you can use for extra trades. The result will be 10 times higher or lower than in traditional stock thanks to the leverage.
The interests are taken at the time of holding a position. This is not the case in stock trading. Here they are calculated from the full-value market position of the CFDs. The rates of interest are specified by the CFDs provider. They, however, depends largely on the base rate of the country in which the trading takes place. For example, LIBOR works for the London Stock Exchange and Fed Rate for the USA.
What is better in CFDs in comparison to traditional stocks?
The first thing that is better in trading CFDs, is the aforementioned leverage. You do not have to spend all the capital to open numerous transactions. Your CFDs provider will require you give only 5% to 10% of the real value of the underlying share. This enables you to trade even 20 times more than you put down in cash. Sometimes it will be even more than 20. This is an incredible opportunity to benefit from the price movements. Another advantage is that you do not have to wait until the money will come back to your account before you open the next trade. So if you see a good entry moment, you can just do it because there is still money in your account as you spend less on a single trade.
You can benefit not only when the price of the underlying asset is going up, but also when it is falling. The contract is for a difference in the price between the moment you open a position and the time you close it. So, with no extra costs, you can take advantage of a share you consider overvalued.
The strategies you can use while trading CFDs are far more advanced. There are many tactics you can implement and make trading simpler.
And last but not least, by trading CFDs you gain access to various international markets like forex pairs, shares, commodities, sectors or indices.
Disadvantages of trading CFDs
- The CFDs providers may set their own rules. Trading CFDs is unfortunately not standardised.
- When you are using leverage, even a small price movement may influence your capital. You may earn, but you may lose as well.
- There is a risk of the counterparty. You do not own the asset, but the contract only. The contract is between you and the CFDs provider. Thus, be very careful when choosing one. Find the broker that is regulated and trustworthy.
CFDs give a great opportunity for traders to benefit from price movements. A trader gains control over a significantly larger position than in traditional stock trading. This is thanks to the margin. And as a result, the profits are much higher. But trading CFDs require also understanding of how to use the leverage correctly. So it is recommended to gain extensive knowledge about contracts for difference before starting to trade them.
Wish you an enjoyable experience.