Newcomers to the financial markets need to decide not only what assets to focus on, but whether to be longer-term investors or shorter-term traders – or a mix of both.
Before examining these approaches, let us clarify one of the most distinct differences. The direct purchase and holding of stocks is most economical for long-term investors, while trading stocks as CFDs is the most effective approach for short-term traders.
Most international online brokers offer CFD trading and do not support direct stock trading. A few brokers offer clients a choice between a CFD account and an Invest account. Understanding the difference between CFDs and investing will assist undecided market participants in making the right choice. Both asset types cater to different objectives and personalities in financial markets.
This article explores the pros and cons of both to help you decide if you should invest in stocks or trade CFDs.
What is the Difference between CFD Trading and Investing?
CFD trading and investing in stocks both provide exposure to the price action of the underlying asset. When an investor buys stocks of a company, the investors get (partial) ownership of the company. Stock ownership can also offer voting rights, but it depends on the share classification. Most investors will buy or sell what is known as Class B stocks, also known as common stocks, and they usually grant voting rights during annual shareholder meetings. While this may sound appealing, retail traders do not have the capital to acquire the number of stocks required to make a difference to corporate governance. Besides purchasing stocks, which is an active form of investing, investors may also choose a passive approach by buying mutual funds or exchange-traded funds (ETFs). Mutual funds have recently lost popularity, especially among retail traders, with capital now flowing into ETFs, which trade similarly to stocks but represent a collection of stocks like a mutual fund, and are traded during market hours, while mutual funds are priced at the end of a trading day.
Most investors do not engage in short-selling or are prohibited from it, meaning they profit only when asset prices increase in value. Investors only have exposure to one side of the market. They remain deprived of the profit potential of corrections and bear markets. It forces them to remain sidelined, and the lost time magnifies missed profit potential. Most investors must trade without significant leverage. It makes investing more capital intensive and limits both the upside and downside potential of portfolios.
CFDs are derivative contracts. They provide traders with exposure to price action without granting ownership of the underlying asset. CFD stands for contract for differences. They have been widely available since the early 1990s and were originally introduced in London. Brian Keelan and Jon Wood of UBS Warburg, rebranded in 2003 as UBS when the Swiss financial conglomerate began operating under a unified brand, wrote the first known CFD contract on their Trafalgar House transaction. CFDs remain a primary trading tool for hedge funds and other smart money operations. They also became the best asset for retail traders, as they deliver notable benefits compared to futures and options. A CFD is an over the counter (OTC) product, and the broker is the direct counterparty to the transaction. Brokers hedge their exposure by placing a trade in the underlying asset on the exchange, which resulted in new regulations requiring disclosure of CFD positions mirroring those of equity positions to counter insider trading. CFDs remain highly leveraged products, providing skilled traders with more benefits. Unlike futures and options contracts, CFDs do not expire, eliminating a significant amount of risk for traders. While futures contracts create a legally binding obligation to deliver assets at a set time, CFDs remain free of such obligations- they only provide exposure to price action. Therefore, CFDs matured into the perfect tool for short-term traders, who can profit from rising and falling markets alike. CFDs are also an excellent tool to hedge equity portfolios.
Share CFDs vs. Stocks and ETFs
Deciding between a CFD or Invest account is a challenge many new traders face. It is best to transact in a product that reflects the personality of the individual. Risk-averse investors with a long-term time horizon should invest in unleveraged cash accounts by purchasing stocks and acquiring physical ownership. While this remains more capital intensive, it limits the downside risk to portfolios. Investors must also consider that upside exposure remains limited. Individual share selection poses a tremendous challenge and the most significant risk to investing. Many retail traders lack the knowledge, patience, capital, and trading tools to achieve consistent profitability. In over 70% of cases, individual investing only leads to a slower loss rate before total loss compared to CFDs. The introduction of ETFs provides investors with a more diversified approach, available even to smaller portfolios. The costs remain low, and hundreds of ETFs carry no additional fees. Most retail investors, especially with portfolios of less than $10,000, can create a long-term beneficial risk-reward balance by using ETFs. The profitability compared to share trading is lower, but so is the risk. Since investors have a long-term time horizon, ETFs offer a cost-effective asset. They display costlier mutual funds, granting exposure to financial markets with the lowest risk profile. Investors can also use ETFs to take advantage of market corrections, as the industry created ETFs that rise in value when markets fall, which is like short-selling CFDs.
Individuals with a short-term time horizon and risk appetite should consider leveraged CFD trading. One aspect to keep in mind when deciding between a CFD vs. Invest account is swap rates on leveraged overnight positions. Traders will pay swap rates to their brokers for the borrowed amount. The more leverage trades use, the less of a margin requirement they face to open and maintain the position. It also increases the amount of money borrowed from the broker, which increases the daily swap rates. Therefore, the longer a trader keeps a CFD position open, the more significant the swap payable, and the bigger drain on any potential profit generated by the trade – except in those few occasions where swap is paid and not charged by the broker. This makes CFD trading perfect for short-term trading strategies but unsuitable for long-term investments. Trading CFDs also requires a more active risk management approach, as profits and losses remain magnified proportional to deployed leverage. While it requires significantly less capital to generate an identical profit or loss in a CFD portfolio compared to an investment portfolio, traders must operate from well-capitalized accounts to achieve a sustainable risk-reward ratio. Two of the most defining risks for CFD traders remain to trade from an underfunded account with expressive leverage and keeping trades open for too long, which can eliminate profits in a sideways market due to daily financing costs in the form of swap rates.
One of the benefits of CFD vs stocks trading is leverage. It also remains one of the most misunderstood trading tools and is often confused with an increase in the risk of losses. Traders must understand that risk management determines losses. While leveraged CFD accounts are the best combination for skilled traders, it does require knowledge on how to use them effectively and efficiently. New traders should approach it with extreme caution and not chase high returns from small portfolios, which practically guarantees losses. Using CFD leverage is only a beneficial tool in the hands of skilled and knowledgeable traders.
Below is an example of CFD leverage vs. the same position in an investment account, buying 1,000 stocks in fictional company ABC at $40.00 per share. The investor has an unleveraged trading account, while the CFD trader uses leverage of 1:20 from an international broker. Many brokers offer 1:500, which is for Forex trading, while liquid equities get 1:20, which results in a margin requirement of 5%. Active traders may negotiate a more beneficial environment.
The total purchase price is 1,000 x $40.00 = $40,000. An investor must pay $40,000 and will have legal ownership of company ABC to the tune of 10,000 votes. Since placing more than 5% of total assets into one transaction represents a high-risk approach, an investor should have at least $800,000 in the portfolio to make this investment. Most retail traders have less than $5,000, which means they should not invest more than $250 into one company. In our example, that would result in 6.25 stocks. Since many brokers do not allow fractional stocks, it typically results in 6 stocks. A 10% increase equals a $4.00 move and results in a profit of just $24.00. Small portfolios will receive better value trading ETFs. They can invest more than 5% of their balance in one ETF, as it is already diversified.
The total purchase price is 1,000 x $40.00 x 5% = $2,000. Using 1:20 leverage means that the trader must pay 5% of the value, while the broker lends the remaining $38,000 for which the trader pays daily interest known as swap rates. Negative balance protection guarantees that the trader cannot lose more than the balance of the portfolio and brokers usually close out all trades when losses trigger a certain threshold. Applying the same 5% maximum position per asset as in the investment account means that a CFD trader should have a $40,000 portfolio to take this trade. Using the $5,000 portfolio example, a CFD trader can afford a trade size of $250 x 20 = $5,000 and buy 125 stocks. The same 10% or $4.00 price move results in a profit of $500. Traders must keep in mind that leverage also magnifies losses by a factor of 20 in our example.
Many new traders make the mistake of taking a significantly larger position. It exposes them to greater risk, which leads to losses. Risk management is the most critical tool in conjunction with leverage. New traders should never take a position greater than 1% to 2% of their portfolio size, irrelevant if they invest or trade. There is no ownership of the underlying asset with CFD trading. CFD traders only seek exposure to the price action of an asset to generate trading revenues. There is no expiry as with options trading, allowing traders greater flexibility and security.
Pros and Cons of CFDs
Let us review the pros and cons of CFDs so that you can make an informed decision.
Pros of CFDs
- Leveraged trading supports smaller portfolios
- No expiration dates
- Excellent diversification and hedging capabilities
- Magnified profit potential
- Best asset class for traders globally
Cons of CFDs
- Swap rates on leveraged overnight positions
- Magnified loss potential
- Many traders misunderstand leverage and engage in reckless trading
Should I invest in stocks or trade CFDs? That remains entirely dependent on your personality, risk appetite, and time horizon. Investing in stocks is for long-term investors, from less risky unleveraged accounts. Trading CFDs is for short-term trading purposes but requires more skill, discipline, and strict risk management. It also carries a higher risk profile and magnified profit/loss potential from leveraged accounts.
It is also worth mentioning that US-based brokers are legally barred from providing access to CFD trading for their clients, as regulators do not allow them. It places US traders with lower deposits at a visible disadvantage, and they then face a choice to satisfy short-term trading needs with either option trading (which can be a less competitive and riskier choice), or trading fractional stocks under new and widely criticized broker models such as Robinhood.
Are CFDs a good idea?
CFDs are excellent for short-term traders with a deep understanding of how to use leveraged products.
What is the difference between CFD and stocks?
A CFD grants exposure to price action in leveraged portfolios without owning the asset. Stocks usually remain unleveraged for long-term investment purposes.
What is CFD investing?
It consists of buying and selling leveraged derivatives without ownership of the underlying asset, solely for price action exposure.
Is CFD trading real?
Yes, CFD trading is real and used by professional traders, including hedge funds and retail clients alike.