If you know that you want to invest, but are not sure whether to focus on CFDs (contract for differences) or the underlying stock asset, you’ve come to the right place. Find out what CFD trading is, the major differences between the two, and more.
Choosing between CFD and stock trading is a big decision. To get started in either, you need to understand some of the key differences between trading CFD stocks and buying real stocks, as well as some inherent advantages and disadvantages of CFD trading.
Here we consider some of the key features of each, to help you decide which is the best option for you.
What is CFD trading?
A CFD (“contract for difference”) is an agreement between an investor and a broker that stipulates the investor must pay, or be paid, the difference between the current value of an asset, and its value at the time of contract.
The agreement is made directly between buyer and seller, and does not require any exchange.
Those trading CFDs will see returns depending on the price at which they “buy” and “sell” a position. If the price difference between open and close is positive, the investor will see returns, but if it is negative, then the investor has made a loss.
The value of a CFD does not take the asset’s underlying value into account, only the price change between the entry and exit position.
Unlike traditional stock investing, CFDs allow investors to potentially profit from price movement in the market without needing to own the underlying assets.
CFDs allow investors to trade in all market conditions. They can speculate on the rising or falling prices of commodities, indices, currencies and individual stocks.
Key differences: CFDs vs stocks
With traditional stock investment, investors buy and sell shares in a company at prices determined by the market. The aim is to make a profit by selling shares in the company at a higher price than that at which they were originally purchased.
With a CFD, investors are not actually buying the underlying asset, meaning they are not buying shares in the company. Instead, they own the contract to receive a price difference, and are solely speculating on how they think the share price will move.
Like any investment, trading either CFDs or stocks comes with advantages and disadvantages. To understand what these are, investors should seek a solid understanding of the distinguishing features of the two categories.
Advantages and disadvantages of stocks
Stocks are one of the most popular investment vehicles, but like any investment, they come with inherent advantages and disadvantages. Consider some in more detail:
- Long-term strategy
Stocks provide long-term stability, unlike the short-term focus of CFDs.
Blue-chip stocks are considered low-risk for long-term investment, and are often accompanied by dividends which support ongoing passive income. - Shareholder rights
Owning company stock grants investors legal rights that can influence operations, including privileges such as voting permissions. - Fees
Relative to CFDs, there are generally fewer costs and lower fees involved in owning stocks.
- Going long
Investing in stocks has a drawback: the inability to engage in short selling. This limitation means investors can only capitalise on price increases. - Market volatility
Stocks, like any investment, can be volatile due to factors such as macroeconomics, earnings reports, and market sentiment. Prices are subject to both increases and decreases, making market timing risky. - Capital Gains Tax (CGT)
Despite having lower fees than CFDs, returns made on stocks will usually be subject to CGT.
Advantages and disadvantages of CFDs
CFDs are a popular way to trade on price difference without having to actually own an underlying asset, but for various reasons, they are considered high risk. Consider some of the potential advantages and disadvantages in more detail:
| Advantages | Disadvantages |
|---|---|
| Leverage trading CFD trading allows investors to utilise leverage, which involves using ‘borrowed” capital. Leverage is a key aspect of CFD trading, enabling investors to reduce the required capital for opening a position. Instead of investing the full trade value, a CFD trader can often use a fraction as a deposit. For instance, a $10,000 x5 leveraged Tesla position would only necessitate a $2,000 investment as the investor’s own capital (referred to as “margin”). | Volatility CFDs are less stable than stocks, with market volatility significantly affecting CFD trading. Continuous monitoring and the ongoing maintenance of margins are crucial to prevent triggering a stop-loss. |
| Trading long or short Unlike traditional stocks, CFDs allow for both long and short trading. This flexibility means that, based on accurate predictions of positive or negative price movements, investors can anticipate potential returns from both increases and decreases in a stock’s value. | Fees CFDs may incur higher trading fees, and while Capital Gains Tax doesn’t apply due to the absence of owned assets, various countries have alternative methods for calculating CFD returns. In Australia, for instance, CFDs are taxed in the revenue section of an investor’s tax return. Profits are included in assessable income, and losses can be claimed as a deduction, taxed according to income. |
CFDs vs Stocks: Which Is Best for You?
Before deciding to trade either CFDs or stocks, it is important for investors to understand the key differences between them, and assess the advantages and disadvantages of each in line with their personal investment goals.
For those seeking a long-term investment, stocks are most likely to be the preferable option. For others, particularly those more interested in short-term trading, CFDs offer the potential to open a large position with only a small amount of capital. Where there is potential reward, however, there is also potential risk; and CFDs are known to be highly risky. This is why, whether interested in stocks or CFDs, investors should always ensure they approach the market with a well-informed investment strategy to appropriately manage the risk of loss.
Learn more about trading stocks and CFDs with the eToro Academy.
FAQs
- What are the costs of trading CFDs?
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When trading CFDs, costs can include a commission, a financing cost, and the spread (the difference between the purchase price and the offer price at the time you trade).
- What is a DMA CFD?
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DMA (direct market access) is the term that refers to electronic facilities, often provided by independent firms, that permit investors or financial firms to access liquidity to trade securities they want to buy or sell.
- Can you receive dividends with CFDs?
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Unlike shareholders, CFD holders do not receive dividends from underlying assets. If an investor holds a long CFD position before the ex-dividend date, they are entitled instead to a payment equivalent to the amount of the dividend.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 76% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work, and whether you can afford to take the high risk of losing your money.