Trading CFDs offers opportunities for you to trade a wider range of instruments than just equities. You can also Sell short and use Leverage to trade larger positions than if you used your cash to buy the stock outright. These factors are particularly advantageous when carrying out a wide range of trading strategies and are explored in more detail here. At the same time a very active share dealing market continues to operate, and understanding the reasons why offers an insight into the use of the different products for different trading strategies.
Generally speaking, the lower transactional costs and ability to scale up positions in CFDs means they are seen as a favored instrument for shorter-term trades.
The mechanics of trading the two instruments on-line are pretty similar. With both you have the option to ‘buy’ or ‘sell’ and input the amount you want to trade. In an example where you have £2,000 cash available to trade and choose to take a long position in the UK company WPP plc then the scenarios for trading in CFD or share form are:
Purchase of WPP plc in Ordinary Share form.
Buy 229 shares at price 870.40 with total consideration/value of £1,993.22
Stamp duty charges (SDRT) at 0.5% of net value: £9.97
Purchase of WPP plc in CFD form.
Taking advantage of the 1:5 leverage offered by your broker platform, using £2,000 as margin, instruct to Buy 1,125 CFD WPP at price 870.40 with total consideration/value of £9,792.00
The difference to the equity position is that the leverage on the CFD account allowed for a multiple of the initial cash deposit to be traded. A larger trade size generates proportionately larger profits or losses.
[The spread on a CFD is studied in more detail here, and in the above example it is assumed the spread on both the equity and the CFD are the same.]
A few hours after opening the trade in WPP the price has risen to 879.20 and shows a profit for both the Equity and CFD positions:
The CFD unrealized P&L is £99.00.
The position has not been held overnight so there are no financing costs to factor into the CFD trade at this time. [Purchase cost = £9,792. Current value = 1,125 x £8.792 = £9,891.00]
The Equity trade unrealized P&L is: £12.48.
[Purchase cost = £1,993.22 + £ 9.97 = £2,003.18. Current value = 229 x £8.792 = £2,015.65]
If you hold the trades ‘overnight’ then financing costs need to be considered as the broker platform will apply a fee to the amount borrowed to facilitate you making the purchase. If you bought the share itself then you won’t pay additional financing charges as you have used your own funds to make the purchase outright. A more detailed analysis of your trading performance might consider the lost opportunity of holding those funds in a savings account as you would have forsaken the chance to earn interest on the balance of £2,000. However, with global interest rates at their currently low levels this is possibly more of a theoretical rather than practical consideration.
The account summary page from the Broker Platform shows the daily charges applied to the WPP position. As below, financing costs of £1.24 have been debited from the account representing one day’s costs.
The pattern that emerges is that share dealing has higher up-front costs than CFD trading but holding CFDs generates daily financing charges. There will be a point, a certain number of days into a trade’s life when buying the share itself would have been cheaper. It is important to understand how these costs influence your chosen trading strategy and typical holding period. The share dealing market remains attractive to some investors with a longer-term investment horizon, who: factor in the financing costs, don’t need the ability to trade short, choose to trade without leverage, want to receive share dividends associated with the position and only want to trade equities.
The trade is closed the next day out at market price of 892.70
The realized P&L of the Equity and CFD trades is price difference x traded amount – costs:
CFD: (892.70p – 870.40p) x 1,125 – 1.24 = £249.64
Equity: (892.70p – 870.40p) x 229 – 9.97 = £41.10
In this case trading CFDs on leverage has meant the profits are a multiple of a trade carried out in equity format. Losses would be subject to the same conditions and also greater trading using CFD rather than Shares.