CFD Trading Explained
Top Forex Brokers
There are five key features of a CFD:
1. Exposure to a stock price movement
A Contract for Difference, or CFD, is a derivative product whose price moves up and down in line with a stock’s price movement. If the value of a stock goes up or down, the value of the CFD goes up or down proportionally with it—this is the major similarity between a CFD trade and a stock trade. So, I can trade the CFD instead of trading a stock directly.
2. No ownership of the underlying stock
In a CFD trade, no physical stock is bought or sold. If I buy the CFD for Apple stock, I own the CFD, not the stock.
3. Over the Counter
CFDs are “Over the Counter” (OTC) products that brokers issue. As with all OTC products, they do not trade through a centralized exchange. If I bought a stock like Apple, it would trade through the NASDAQ exchange.
Without an exchange, the broker controls the price and fills of CFD trades.
Brokers require a deposit or margin to open a CFD trade, which is usually less than the total outlay of the stock, meaning CFDs offer leverage. Let’s say a broker offers 3:1 leverage for CFDs—I would need $33 to buy a CFD for $100 worth of stock.
5. No restrictions on short trades
Brokers do not restrict short trading on CFDs. There can be some short trading restrictions with stocks.
Stock Trading Explained
Here are the primary features of stock trading:
1. Stock trading takes ownership of the stock.
Stock trading means buying or selling the actual stock. If I take a long trade, I physically own the stock, and that makes me a company shareholder.
2. Stocks are mostly traded through exchanges.
Stocks trade through centralized exchanges (the New York Stock Exchange, NASDAQ, the London Stock Exchange, etc.) The exchange controls the price and filling of trades, not the broker—the broker provides access to the exchange.
3. No leverage.
Brokers typically offer no leverage to retail traders for stock trading. Without leverage, I must have all the capital for the value of the stocks I wish to trade. If I want to buy $100 worth of stock, I must put up $100 of capital for the trade.
4. Exchanges and brokers can restrict short selling.
Some exchanges can restrict short-selling stocks, especially under certain market conditions. Brokers also have rules that sometimes restrict short trades on stocks. For example, to sell a stock short, the broker first must borrow the stock from another account to lend to me to sell short —if the stock is not available to borrow, I will not be able to short the stock.
What are the Differences Between Trading CFDs and Stocks?
1. Ownership of the stock.
- Stock trading: I own the stock and become a company shareholder with voting rights.
- CFDs: I am not a stockholder because CFD trading does not buy or sell the underlying stock.
2. Leverage
- Stock trading: Most brokers offer no leverage for stock trading, meaning I will have to have the entire capital amount to purchase the stock.
- CFDs: Brokers offer plenty of leverage for CFD trading, meaning I will need a fraction of the value of the trade to open a position. Leverage effectively increases the value of my account and magnifies potential profits. However, leverage also magnifies losses and is an added layer of risk.
3. Exchanges vs. OTC
- Stock trading: Stocks are generally traded through exchanges—the exchanges control the pricing and fill of trades. The broker’s role is to provide traders access to stock exchanges.
- CFDs: Brokers create and issue CFDs directly to their customers without going through an exchange. This is known as “Over the Counter,” or OTC, where traders rely on the broker’s fills and pricing.
4. Short trades
- Stock trading: Brokers and exchanges can restrict some short trades, including not allowing short trading under certain market conditions or on specific stocks.
- CFDs: Brokers allow short selling on any CFD product at any time.
5. Trading hours
- Stock trading: Trading hours are set by the exchanges and are usually based on business hours in the exchange’s time zone.
- CFDs: Most brokers allow CFD trading 24 hours a day.
CFDs vs Stocks: Comparison
Let’s see an example of CFD leverage vs. the same position buying stock directly in an investor account without leverage: 1,000 shares 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.
Investment Account
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, so 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, resulting 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, which is already diversified.
CFD Account
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 portfolio’s balance, 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 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. Remember 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 & Cons of CFD Trading
Pros
- Leverage.
Access to leverage effectively magnifies the size of my account. Let us say my broker offers me 3:1 leverage, and I have a $1000 account; I can enter $3000 worth of CFD trades. If a stock moves in my direction by 1%, my profit will be 3% on my account. Leverage is also especially great for stocks that do not move much, i.e., have low volatility.
- 24-hour trading.
24-hour access to trading gives me the flexibility of trading any market regardless of time zones and whether I can be available at certain times of the day.
- Easy to take short positions.
Brokers set no restrictions to shorting CFDs. This expands the number of trading opportunities, especially in bear markets when the best trades are often short positions.
Cons
- OTC market controlled by the broker.
Brokers issue CFDs directly to traders without an exchange to ensure fair pricing and trade fills—I rely entirely on the broker’s fills. Without the safety and rules a central exchange provides, picking the right broker is essential to CFD trading. Although today, some regulatory bodies regulate CFD brokers in their jurisdiction to help ensure fair trading practices.
- Leverage adds risk.
Leverage is often seen as only a positive feature because it increases the value of profitable trades. But leverage works both ways—it also increases the value of losses.
- Overnight fees.
Most brokers charge fees for holding CFDs overnight, making them more expensive for longer-term trading. Apart from the costs, this could negatively impact a trading strategy—for example, I may exit trades early to avoid fees, even if the price subsequently hits a longer-term target.
Pros & Cons of Stock Trading
Pros
- Ownership privileges.
Buying stocks directly is the purest form of trading—I affect the supply and demand, which is how the price of any asset moves. It is good when true buyers and sellers determine the price through their actions because that is how a healthy financial system should work. I also get voting rights and get to attend shareholder meetings. Very few of us think about the ethics of how we trade—but from that standpoint, trading stocks directly is the most ethical way to participate in equities.
- No overnight fees.
Buying stocks without leverage means no overnight fees. That gives me tremendous flexibility—a short-term trade may turn into something longer-term, and I can trade according to a solid strategy rather than exiting trades prematurely because of fees.
- Regulated exchanges.
Nearly all stock trading happens through regulated exchanges such as NYSE, Nasdaq, etc. Exchanges have rules and procedures for filling trades, so some traders consider exchanges the fairest and safest way to trade.
- Losses are limited to the initial investment.
The risk in long stock positions is always capped to my initial investment because there is no leverage.
Cons
- No leverage.
Most brokers offer no leverage to retail traders for trading stocks. If I want to buy $100 worth of stock, I need $100 of capital.
- Limited trading hours.
Most stock exchanges have limited trading hours, usually focussed on the business hours in their time zone. For example, the New York Stock Exchange (NYSE) is in the Eastern Time zone (ET) and is open from 9:30 am to 4 pm ET, Monday to Friday, excluding specified holiday days, such as the US Independence Day. If I live in that time zone and work during the day, I will find it challenging to place trades during market hours.
- Cannot always go short.
Depending on market conditions, exchanges such as the New York Stock Exchange restrict some short selling.
CFD vs Share Dealing: Which Instrument to Choose?
Should I invest in stocks or trade CFDs? That depends entirely 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 magnifies leveraged accounts' profit/loss potential.
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 options trading (which can be a less competitive and riskier choice) or trading fractional stocks under new and widely criticized broker models such as Robinhood.
Bottom Line
CFDs are one of the most popular methods of trading stock price movements. Instead of buying or selling a stock, traders can buy or sell the equivalent CFD. They offer considerable advantages, including leverage and 24-hour trading.
Brokers issue CFDs directly to their clients, and CFDs do not trade through regulated exchanges, so they trade Over the Counter (OTC). Regular stock trading happens through exchanges which provide rules for trade execution. In CFD trading, the brokers control pricing and execution, making picking the right CFD broker an essential part of trading.
Brokers charge fees to hold CFDs overnight, making them more expensive for longer-term trading.
In CFD transactions, traders do not own the stock; they own the CFD. They have no voting rights and cannot attend shareholder meetings like regular stockholders.
CFDs can be a great way to trade stock price movements under the right conditions.
FAQs
Do professional traders use CFDs?
Yes, CFDs have been around for decades, and many professional traders earn their living from CFDs.
Are CFDs a good investment?
Yes, CFDs give round-the-clock access to stocks and other markets worldwide with leverage and low costs.
What are the two biggest differences between real stocks and CFD stocks?
CFD stocks trade with leverage and not through exchanges. Real stocks often cannot be traded with leverage and only through exchanges during market hours.
Why are CFDs banned in the USA?
One reason is that they are over the counter (OTC) products, meaning they do not pass through regulated exchanges.
Are CFDs riskier than stocks?
Yes, because CFDs have leverage which makes them riskier.
Does 1 CFD equal 1 share?
Yes, a single CFD contract has the same value as buying one share in the underlying company.