June 4, 2021 | AtoZ Markets – If you regularly watch a financial news channel, there's a good chance you'll expect stock market experts to talk about stocks, bonds, or commodities like gold or oil. They are popular financial products and most investors are already familiar with them. However, there are other financial products that are less well known and that investors don't understand enough.
One such product is CFD (contract for difference). It is an increasingly popular derivative product and many online brokers offer it.
How is CFD vs invest different?
CFDs vs Investment
Before explaining what the difference is between CFD vs investment, let's review what each of them is about:
What are CFDs?
So basically, CFDs are financial derivative instruments that allow traders to take advantage of prices moving upwards (long position) or prices moving downwards (short position) on underlying financial instruments. CFDs are contracts by which two parties agree to exchange the difference between the entry price and exit price of an underlying asset (stocks, securities, commodities, currency pairs, cryptocurrencies).
In other words, acquiring a CFD on a share does not make you the owner of said share, but rather you are buying a contract with the broker, which will be in charge of trading them according to the position you opened.
What is investing?
According to legendary investor Warren Buffett, investing is “the process of depositing money now to receive more money in the future.” Yes, investing is a popular method of getting involved in financial markets with the goal to build wealth in the medium to long term.
When you invest in stocks, you are investing in the company that issues them. Consequently, you should focus on the core characteristics of the company, including its long-term growth plan.
Taking this into account, we will compare both CFDs and investing to find out what the difference is between them.
Difference between CFD vs invest
Contracts for difference and investment create confusion for new traders because they are very similar. But one of the big differences between the two is that with CFDs, you don’t purchase the underlying asset, whereas investors take ownership of the asset, meaning you’ll benefit from any upward price movements.
Other differences that exist between CFDs and investing are the following:
CFD traders avoid keeping any positions open for longer than 24 hours. On the other hand, investing usually involves buying assets and holding them for months or years, looking for longer-term returns.
Investors in stocks, ETFs, and mutual funds can expect to receive dividends, but not when trading CFDs. CFDs are synthetic products and you are not invested in any real assets.
CFDs are free from stamp duty because you don’t own any assets. However, you'll pay capital gains tax on profits made. Losses can be offset against profits as a tax deduction. In contrast, investors pay stamp duty on each deal and capital gains tax on profits. However, share positions opened using stocks and shares ISAs are tax-free.
CFDs come with three key advantages over investing:
- going long and short,
- available markets.
CFD vs invest - Pros and cons
Before making an investment, you need to know the pros and cons. Knowing this, you can be fully aware of the risk you are taking and whether the risk outweighs the benefits.
The advantages of CFDs
CFDs offer great flexibility to traders and speculators. CFD trading wouldn't be that popular if it didn't have certain advantages for traders.
CFD brokers do not require the trader to commit the full value of the trade, thanks to the leverage effect.
Leverage allows you to gain a
large exposure to the markets with a small deposit.
Few private investors can afford to buy, say, a stock of Amazon for $3,000 and pay the full cost. But with CFDs, a broker offering leverage of 1: 100 will only ask you for $30 margin to buy the equivalent of an Amazon stock. CFDs, therefore, allow traders with limited capital to take advantage of the financial markets.
Going long and short
When it comes to investing, you can only make a profit when the price of an asset appreciates. On the other hand, when you trade a CFD, you can speculate on the price movement in both directions.
So, if you think Amazon's stock price will drop, you can short sell it by opening a short position on its CFD. You can do this because CFDs are derivative products and you don't need to own Amazon stock to sell their CFDs.
If you have sold an AMZN CFD and the group's share price falls, you make money by buying back the CFD at a lower level and pocketing the difference between the entry and exit prices.
No expiration date
Unlike other derivative products such as options or futures, CFDs are not subject to time constraints. They have no fixed expiration dates and have far fewer restrictions on closing positions.
This provides considerable flexibility for scalpers who can come and go at any time without constraints.
Disadvantages of CFD trading
CFDs are risky products. Caution is needed.
Leverage causes greater losses
CFDs can cause you to lose more capital than you expected. Leverage is a double-edged sword that can amplify your gains as it can increase your losses.
In fact, the potential losses could be greater than the expected profits, as we have shown in the previous examples. By trading 100 ounces of gold with 1: 100 leverage, you are losing $5,100, which would be more than half of your equity, if the price dropped by just $50. On the other hand, if you bought physical gold, the loss would only be of $50, which corresponds to a 0.5% drop in your equity.
Possibility of manipulation by the broker
Many traders have complained of arbitrary slippage or requotes when placing their orders via CFDs. While instances of broker price manipulation remain a rare occurrence, it is entirely possible.
There is hardly any fraud in centralized markets, as the exchange controls all transactions. There is no such authority for CFD contracts that are offered directly by brokers to clients.
There are many ways unscrupulous brokers can fool novice traders. You can avoid being a victim by making sure your broker is well regulated.
CFD trading example
Commodity CFD trading is relatively popular. We will show you an example with gold.
Let's say you want to buy 100 troy ounces of gold at $1,800 and choose a CFD broker that offers 1: 100 leverage on those assets. Here you would need $1,800 to open the position:
(100 x $1,800) / 100 = $1,800
To calculate the exact transaction costs, we need to consider that the broker is taking the spread or a commission.
In this example, let's assume your chosen broker charges you $0.5, which brings the purchase price to $1,800.50:
(100 x $1,800.5)/100 = $1,800.50
If the gold price were $1,850, your order would be filled at the sell price of $1,849.50 assuming the spread remains the same at $0.5. So your profit would be $49 for every ounce of gold:
($1,849.50 - $1,800.50) = $49
But remember that you bought 100 troy ounces of gold, which resulted in a total profit of $4,900 on the position:
(100 x $49) = $4,900
Assuming you had $10,000 of equity in your trading account, this would mean you made a 49% profit on the transaction. Compared to a trader who bought physical gold at the same price, the profits obtained from CFDs are much higher. If I had purchased physical gold, the profits would have been only $50 minus the transaction fees.
($1,850 - $1,800) = $50
However, you can't always make a profit and sometimes you will suffer a loss. Now imagine the price per ounce went from $1,800 to $1,750. By keeping a constant spread at $0.5, you would be selling the gold you bought for $1,749.50, with a loss of $51 per ounce. In this case, the loss would be $5,100:
($1,800.50 - $1,749.50) x 100 = $5,100
If you consider you have $10,000 in equity, it means you have lost 51% of your equity on the transaction. Some brokers have a stop-out level which involves closing open positions if a certain percentage of your capital is lost. For added flexibility, some brokers allow you to set your own stop-out level.
Brokers who charge a spread and commission
Some CFD brokers apply tighter variable spreads, but have a fee that depends on the size of the position. To see the effect of that price, consider a broker who charges a $0.1 spread on gold and a commission of $3.50 per lot.
Since a standard lot of gold is 100 troy ounces, the total transaction fee will be $7 (entry + exit). Including the $0.1 spread, the total profit on a winning trade would be $4,973:
Purchase price = $1,800.00 + 0.1 = $1,800.10 sale
Price of = $1,850 - 0.1 = $1,849.90
Profit = (($1,849.90 - $1,800.10) x 100) - $7 = $4,973
As you can see, the profit made on the transaction is also greater with the commission. The losses will also be slightly lower:
Purchase price = $1,800.00 + 0.1 = $1,800.10 sale
Price of = $1,750 - 0.1 = $1,749.90
Loss = (($1,800.10 - $1,749.90) x 100) - $7 = $5,013
What financial products could be traded as CFDs?
CFDs can come from any type of financial instrument.
There is no limit to the products that can be traded as CFDs as long as there is a market for it. In fact, CFDs are so simple that contracts can be created from any listed asset.
That said, the most traded CFDs are in stocks, stock indices, and metals. US stocks, in particular, especially tech stocks like Amazon, Facebook, and Google, have become very attractive due to the growth of the industry. Metals (gold, silver) and oil are also very popular.
Since the bubble in the cryptocurrency market, virtual currency pairs are also offered by most CFD brokers. This has a huge advantage for speculators who can take advantage of their fluctuations without having to set up cryptocurrency wallets.
All of these stocks are traded on the global stock markets, so it is easy for a CFD broker to partner with liquidity providers to provide quotes. Furthermore, these markets are very liquid, which guarantees traders access to assets at attractive prices. The best brokers work with liquidity providers around the world to be able to offer the best prices.
CFD Trading Strategies
Choosing a trading strategy is an important decision a trader can make.
There are many trading strategies, very different from each other.
The strategies most used by large and small traders are:
- Day trading: is a trading strategy where the trader opens and closes all their positions before the markets close. With this strategy, you avoid additional costs such as an overnight position.
- Position trading: with this strategy the open positions are kept open for a long period of time, weeks, months, or years.
- Swing trading: a set of technical and fundamental analyzes is used to determine the “ swings ” in the price changes of an asset. A swing is when a certain price of an asset swing up or down.
- Trend trading: This strategy depends on the prevalence of a trend and can be a short, medium, or long-term strategy. Traders must be able to understand when to open and close their positions in order to maximize their earnings.
- Scalping strategy: This is a form of Day Trading that involves opening and holding the position for a very short period of time, a few minutes but also, sometimes, a few seconds.
CFD vs invest - Conclusion
In summary, having seen the difference between CFD vs invest, it is now your decision to determine which of them best suits your investment needs. CFDs offer a number of benefits to traders. But due to their large potential earnings, this type of investment always poses a significant risk. Therefore, relevant analyzes must be done carefully before opening a position, and risk management become even more important.