CFD trading and investing: You must have heard of these terms if you are a neophyte in the finance world. They might appear to be the same thing but, in fact, they function very differently having nothing not only with respect to your strategy or risk tolerance depending on what you choose ultimately rather regards to your end targets financially.
Here they are broken down to give you an idea of which might be right for you.
What is CFD Trading?
CFD means Contract for Difference. Basically when you trade CFDs, you are not buying the underlying asset itself (e.g. a physical share or commodity). What you are actually doing is entering a derivative contract with the broken to take on some form of risk that an asset will rise or fall. In other words, you are wagering whether the price will increase or decrease.
One of the amazing features in CFD trading. In order to open a position you need only have certain percentages of the value of that trade. This enables you to trade more than your account balance would normally indicate, but it also increases risk.
In CFDs, you can play both long (buy) or short (sell). Therefore, it allows you to make a profit when prices rise and you lose money if prices fall.
You never truly own the asset — you are simply betting on price. Whatever it may be — currency, gold, oil or a company's stock. CFDs do not provide any dividends and there is no voting rights.
Example of CFD Trading
For the sake of this example, let's say you expect Apple (AAPL) stock to increase in price on a short-term basis.
AAPL Current Price: $150 per share.
So you decides to open a CFD position with 10:1 leverage, depicting for every 1$ put up by YOU; it represents 10$ control through stock.
By putting just $1,000 in your CFD account you are able to control actions worth of Apple (approximately 66 shares x$150).
Scenario 1: Price Rises
- AAPL stock rises to $160 per share.
- Your profit would be $10 per share for 66 shares, totaling $660 profit.
- Return on your $1,000 investment is 66% in a short time.
Scenario 2: Price Falls
- AAPL stock drops to $140 per share.
- Your loss would be $10 per share for 66 shares, totaling $660 loss.
- Since CFDs are leveraged, a drop can quickly wipe out a significant portion of your account, bringing your balance down to $340 ($1,000 - $660).
Key Points
You can gain or lose money with CFD trading when the prices of assets move even though you don't own them. Using a leverage means you can trade positions larger than your current account balance, but it simultaneously increases the risk to lose more than your deposit.
What is Investing?
Investing is more straightforward. It often involves the purchase of an asset (such as shares in a corporation, bonds or real estate) and is expected to spread its use for at least over time resulting in some type of residual income such as interest, divide distribution. That can be in the form of capital appreciation (the value increases) or as income, e.g., dividends.
When you purchase shares/stock of a company, this means that you own some ownership in the same. This gives you the right to dividends and voting rights.
Investing is usually done with a long-term time frame. You invest in assets expecting them to appreciate over the time. Patience is key in investing.
Unlike CFD trading in which leverage is used, investing usually includes no use of any kind of leverage.
Example of Investing
Now, let’s consider traditional investing in the same Apple stock.
Current AAPL Price: $150 per share.
You decide to invest $1,000 directly in Apple stock, buying 6.67 shares.
Scenario 1: Price Rises
- AAPL stock rises to $160 per share.
- Your total value would increase to $1,067.20 (6.67 shares × $160).
- Your profit is $67.20 or 6.7% on your $1,000 investment.
Scenario 2: Price Falls
- AAPL stock drops to $140 per share.
- Your total value decreases to $933.80 (6.67 shares × $140).
- Your loss is $66.20 or 6.6% of your initial investment.
Key Points
With an investment, you are the owner of shares and they appreciate or depreciate in value. You also have no leverage so your only potential loss would be limited to the dollar amount you put in. You also receive dividends, and you can keep the stock in your portfolio forever if growth comes along.
This makes investing a slower, more likely long-term and less risky route of owning the asset. Although, it does require you to put in the full capital upfront and gives no leverage for short term.
CFDs vs Investing — Key Differences
CFD trading and investing are two popular ways which many people use to make money in the finance world, though they differ greatly. We explore five major differences between them: Ownership, Leverage, Risk, Time Horizon, and Costs
1. Ownership
Ownership is the principal difference between CFD trading and investing.
When you trade CFDs, you are not transferring actual assets. Instead, you are placing a wager on the direction that an asset (a stock or commodity) will move. You never actually own shares or physical commodities.
On the other hand, in typical investing, you own the asset. You can for instance buy shares in a company, and then you are the direct owner of some part of that company. Being that a shareholder means you are eligible to receive dividends and other perks of the shareholding nature.
2. Leverage
The second major difference is leverage, which will impact the capital needed to get started and subsequently returns (and risks).
CFD Trading: CFDs are complex instruments. This implies you can control a huge position with just a minimal amount of your own cash. What that means is, only by putting up $1,000 you could control a position of $10.000 (this would give you 10:1 leverage). It is higher potential profit and loss in the same way.
Investing: On the flip side, traditional investing usually doesn't use leverage. As you fork out the entire price of the asset right away, your potential returns and losses are capped at what you invested initially.
Read Also: Things You Should Know about Leverage in Forex Market
3. Risk
The risk associated with CFD trading is vastly different to the one of investing.
CFD: (CFD Trading: CFDs are more riskier, because leverage is not fixed). Although a small market move can bring heavy profits, it may also cause huge losses. You could have a lot more money to lose than your original investment if the market turns on you.
Investing: A method of potentially building wealth that carries much less risk than one more ‘active’ earnings phenomenon (discussed later in this post) but still involves some type of risk. The reason for this is that you are trading without leverage so your losses would be limited to what you invest. The risk is less than with CFDs, even for a long-term asset.
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4. Time Horizon
The specific time horizon for CFDs and investment can also change based on strategies or market behavior.
CFD: CFDs are short-term in nature. Traders normally use CFDs for daily or even hourly prices increments. Most CFD trades take entry and exit on the same day; for longer-term positions.
Investing: Investing is typically longer-term investing in fortunes. Investors purchase assets such as stocks, bonds or real estate in the hope of holding them for a number of years and having their value increase.
5. Costs
Both CFDs and investment come with cost but this differs in how they are applied.
CFD Trading: There may be several types of costs that CFD traders could potentially face, such as:
- Brokerage fees for buying and selling stocks.
- Spreads, i.e., the price difference between buying and selling the asset
- Fee on holding positions overnight as well (known as swap fees)
Traditional Investment: The traditional investment usually has;
– Transaction costs to buy or sell another asset.
- Management fees if you've invested in mutual funds or safe, which are paid by investment managers for managing the benefits.
Knowing the distinction between CFD trading and investing is essential for smart financial moves. A CFD is known to be a high-risk financial product that can provide higher leverage and short term opportunities. On the other hand, investment is a longer term process that usually includes ownership of assets and less risk because it carries no leverage.
Your investment decision between these two also depends on your financial goal, risk tolerance factor to a great extent. If you want to make quick trades with higher risks, CFDs may be the one for you. But if you are interested in growing your wealth methodically over time, regular investing is probably the right fit.
Advantages and Disadvantages of CFD vs. Investment
CFD trading and investing both have a unique way of benefiting from the financial markets. Learn about some of their benefits and drawbacks, so you can select the right product for your objectives, risk appetite and trade style. Let's break them down.
CFD Trading: Pros and Cons
Pros
- It gives you the flexibility to control a large position with limited capital outflow. This, in turn, provides a substantial profit potential with lesser capital at the onset.
- CFDs let you go both long and short. No matter which direction the market is headed, you can profit.
- You can trade contracts on an assets without physically owning that asset, so this makes the trading across multiple markets: commodities, stocks and currencies; much more convenient.
- CFDs gives you access to global fainancial markets
Cons
- Leverage magnifies gains and losses. So you can loss more than your initial capital.
- Keeping the CFD position overnight attracts higher financing cost which can reduce profits in a longer period.
- You will not get dividends or voting rights for stocks, since you do not own them.
- The time periods are usually short in the world of CFD trading, and it requires a lot attention to be paid constantly on what is happening in the market.
Investing: Pros and Cons
Pros
- When you invest, you own the asset i. e stock, bond or real estate etc which will give you profit in long term due to benefits like dividend, capital gains and Interest. So that way you are lasting value.
- Well, investing is meant for the long run. You can get anything in terms of income like dividends or price appreciation.
- Trading traditional investments has less risk than trading CFDs because there is no leverage involved. You can only lose the amount you invest.
- There are no overnight financing costs in Investing so it works out cheaper over the long run.
Cons
- Unlike CFDs, you need to have the full price of an asset whereas more capital is required.
- Returns of traditional investing tend to be slower. You can not benefit from reverses until now with complicated strategy.
- Investment profits in a general sense are motivated by market growth. When the market crashes, your portfolio can be crushed.
- Buying into mutual funds or ETFs can have management fees, and every trade costs you in transaction expenses.
CFD trading is ideal for short-term with high-risk. Investing, on the other hand, is better for those with a long-term horizon.
Which is Right for You?
– If you want short-term opportunities, and don't mind high-risk then CFD trading is for you. For experienced traders who want money in both rising or falling markets CFD trading can be of interest. However, it does require close attention and a good understanding of market forces.
- Investing, in contrast, is for people who have more of a long-term mentality and want to build wealth slowly over time. If you do not want to sit at a screen all day, and are fine with periods of both ups & downs; then traditional long-term investing might be more appropriate for yourself.
Final Thoughts
Both CFDs and investing have their own advantages, but depend on what your financial goal is (also how much risk you are willing to take). Knowing your personal financial objectives and risk tolerance will help you determine which route to take. CFD trading can yield big profits, but it also carries substantial risk. While more stable, investing takes time to see significant gains.
Finally, regardless of whether you choose CFD trading or investing keep in mind that education is crucial and it's always good to know what exactly are we putting our money into.