Traders’ choice: CFDs or shares?

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Updated: 04 March 2020

Legendary names such as Wall Street, the Nasdaq and the S&P 500 are never far from the news, and neither are their global counterpart trading exchanges set in various countries. Investors of all sizes, from major international hedge funds to individuals with DIY portfolios, have bought and sold shares in companies listed on these different exchanges for many years.

Their money has traditionally increased or decreased depending on the performances of those companies and the movements of the markets in general. Today, the sophistication of trading goes far beyond the simple purchase and sale of stock, as various derivatives have widened the boundaries and made it possible to make trades without ever owning the actual assets.

Contract for difference (CFD) trading is one such financial instrument, but it is very different from the older styles of derivatives. This is why CFDs are so popular and why many people are choosing them as their trading preference above traditional dealings with stocks and shares.

Derivatives

CFD trading is based on the idea of making a profit from the price movement of an asset without actually buying the asset itself. CFDs are a truly “derivative” financial product because ownership of the underlying asset does not occur at any point. However, older types of derivatives such as futures and options differ from CFDs. In a futures contract, a trader agrees to buy or sell an asset at a set price at a particular time, and an option gives a trader the chance to buy the underlying asset without obligation.

Assets such as a share in a listed company, a commodity or a market index can all form the basis of a derivative trade since they all offer traders the chance to take a position as to how the value of the underlying asset will change over a period of time.

Leverage

Because the main difference between trading in shares and CFDs is the actual ownership of assets, investors only need to have a small percentage of the value of the asset as security when trading in CFDs. This type of trade is essentially a contract between the client and the broker, making it an extremely efficient instrument to use to invest over the short term.

This kind of “leveraged product” makes opening accounts easy and comes with many benefits, such as capital gains. Also, in the UK, CFDs are exempt from stamp duty, which makes them even more attractive.

The low capital outlay together with high potential returns may seem to be too good to be true, and of course there are risks. However, successful CFD traders tend to be extremely disciplined and use highly developed strategies to help them avoid losses.

Technical analysis

CFD traders are interested in fast-paced movements because the price changes are the only criteria for success as opposed to the overall health of the underlying assets itself. This means that long-term projections for a company are no exactly worthless but not nearly as important as they would be for a share investor wanting a prolonged return.

To calculate the movements of prices, many CFD investors seek technical analysis to make use of short-term indicators that work over the time-frames needed.

Risk and return

The first piece of advice that anyone buying shares should receive is “Your investment may go up or down.” The risks are very real, even for those who only choose blue chip stocks at the wrong time.

Risk management is a key element to any trading position, and although some people feel that leveraged products as a whole can be dangerous, various strategies and damage limitation tools can build into CFD trades.

Growing popularity 

Just because a trend gets more popular does not mean that it actually has value, but when it comes to CFD trading both in the UK and elsewhere, there is no doubt that more trades are happening every day.

The popularity of CFDs, especially trades involving currencies on the forex markets, is all to do with the flexibility that is inherent in the system. While traditional derivatives such as futures and options have set time periods, a CFD trade can lengthen to take advantage of positive circumstances. Traders do not need to hold long or short positions with gritted teeth in the hope that circumstances will change, and low commissions and tax benefits are the icing on the cake for many.

Switching

Investors who are fully at the risk-averse end of the spectrum will always be wary of trying something new, and they usually buy into funds that have built a reputation for slow movements and long-term approaches to traditional stocks and shares

For those who want a different approach and are more willing to look at a manageable risk/reward balance, the plethora of financial instruments and products available to choose from really provides good opportunities.

CFD trading requires active involvement, and short-term traders have an interest in the fast-moving environment that naturally follows an approach based around gains derived from price movements. With more investors not only dipping their toes into the waters of CFDs but also actually making a complete switch from traditional share trading, the future for CFDs looks certain to go from strength to strength.