How do CFDs differ from stocks and which option is right for you?

How do CFDs differ from stocks and which option is right for you?
This article has been sponsored by IG Markets.  

Contracts for difference, or CFDs as they are more commonly known, are one of the most prevalent and innovative tools for trading. Put simply, CFDs offer the chance to trade on the rising and falling prices of assets in financial markets, including currencies, indices, commodities, and of course, stocks.

While CFDs and shares can appear to be quite similar at first glance, they differ in a variety of ways. For more clarity on the key differences, we reached out to IG Market’s Deputy Head of Dealing, Thomas McCrickard.

Ownership

When it comes to stocks, it’s pretty straightforward, you buy a stock, you own it — it’s yours until you sell it. This isn’t the case with CFDs, which you don’t technically own.

“With a CFD contract, the trader has no ownership of the underlying asset. It’s simply an agreement between two parties to pay or receive a sum of money as the price of an asset changes,” says McCrickard.

“This two-party arrangement is known as OTC (over-the-counter), rather than on-exchange, which is why CFDs are often referred to as OTC derivatives.”

Positioning

CFDs allow you to not only profit from an asset price rising, but also give you the option to ‘short’ a stock by effectively betting against it.

“Since CFD trading doesn’t involve ownership of the asset, this means it’s possible to take a long (profiting if the price goes up) or short (profiting if the price falls) position using a CFD contract,” says McCrickard.

Leverage

CFD trading is often referred to as ‘trading on margin’ because the funds required to open and maintain a position — the ‘margin’ — represent only a fraction of its total size.

“CFDs are typically traded using leverage, where traders put up only a fraction of the value of their total position as margin in order to place a trade. This magnifies both profits and losses, and can result in a margin call if the trader’s margin is depleted.”

Product Range

As mentioned, CFDs allow you to broaden your horizons and trade beyond the traditional stock market. Contacts for difference can be used to take advantage of pretty much anything your heart desires. Well, almost anything.

“Since a CFD is simply a contract it’s not limited to speculating on the price of shares. You can trade using a CFD on anything from the price of Microsoft to the price of Lean Hogs.”

Costs

“It’s tricky to generalise for costs on CFDs or Share Trading. Both involve a cost at the point of trade, whether through spread or commission,” says McCrickard. “The key difference is that with CFDs an overnight funding cost is incurred when holding a position. This is not the case with Share Trading, and it’s why it’s the preferred instrument for longer-term investment.”

“By contrast, with share trading, you’re buying a share that trades on exchange, and that you will have ownership of. It’s only possible to take a long position.”

Risk

Buyer beware, with great power comes great responsibility — you can lose just as quickly as you can win with CFDs. Traders need to be careful.

CFDs carry risk in the same way that share trading carries risk — if the share price moves against you, you lose money. However, the risks associated with CFDs can be greater because they are leveraged products. Leverage enables you to gain a large exposure to a financial market while only tying up a relatively small amount of your capital. In this way, leverage magnifies the scope for both gains and losses.

Why you might want to consider CFDs

Basically, CFDs can be a good option for short to medium-term trading, as well as for speculation and hedging. And this is their key advantage. With stocks, it’s more of a long game, but CFDs allow you to chase faster returns.

“With CFDs, you don’t own the asset, you’re simply speculating on its value. This means that you can take a long or short position on a market, and can trade with leverage. This magnifies both profits and losses. Due to their inherent leverage, CFDs typically involve an overnight funding charge, along with an upfront fee at the point of trade,” says McCrickard.

“This is why share trading is often the preferred long-term investment product, while leverage, and ability to go long or short with CFDs often appeals to short-term traders,” he adds.

And of course, as McCrickard mentioned, the fact that CFDs are fundamentally just a contract between two parties, you can trade a CFD on almost any financial product. This fact alone can prove a tantalising prospect, allowing for retail clients to access futures or foreign exchange markets they’d otherwise have difficulty accessing, or in some cases, no way of accessing at all.

Interested in learning more about CFDs? Head on over to the IG Academy.