Which is Better for You - Stocks or CFDs? What is The Different?
In the financial world, stocks and Contracts for Difference (CFD) are two important investment instruments. Each offers unique opportunities and risks to investors like you.
Stocks represent ownership of shares in a company, allowing you to benefit from dividends and capital appreciation. On the other hand, CFDs offer a way to speculate on the price movements of assets without owning them, leveraging the potential for gains from market fluctuations.
We understand that many traders wonder which of these two common financial instruments is right for them. For this reason, our experts at Arincen have prepared this article to demystify these two options, comparing their characteristics, advantages, and considerations.
Understanding Stocks and CFDs
The two types of financial instruments are related, but they are distinct investment products, each with its advantages and disadvantages.
Stock Trading Explained
If you own stocks, you have ownership in a publicly traded company. When you buy a stock, also known as a share or equity, you are really buying a small piece of the company in which you are investing. With publicly traded companies, the gross value of a company's stock is divided into shares, and each share represents a portion of the company's assets.
When a company issues new stock, as it can do frequently, it uses the money it earns to fund its operations, capitalize new projects, or dish out dividends to shareholders. Shareholders, like retail investors, can also profit from the growth of a stock's value over time or receive payment in the form of dividends.
Stocks are traded on exchanges where buyers and sellers congregate to trade shares. The value of a share is determined in large part by supply and demand in the market, with investors constantly negotiating prices based on such factors as the company's financial performance, industry trends, and economic news.
You might wonder if you need a broker to trade in stocks? It is not mandatory to use a broker. You can handle your purchases on your own through direct access trading. However, the vast majority of traders find it worth the time and effort to use a broker as it is also just more practical. This is because brokers are experts in the field who can offer guidance and advice and can shorten the learning curve of trading stocks. The truth is that trading stocks on your own can be tricky, especially if you are a newbie. This technical and complex field often calls for a broker.
CFD Trading Explained
CFDs are financial instruments that allow traders to speculate on the price movements of various financial markets without owning the underlying assets. They are common in the FOREX world, but can be applied just as easily to a range of markets, such as stocks, indices, commodities, and cryptocurrencies.
As a trader, you enter a CFD contract because you believe you can predict if an underlying security, such as a Tesla stock, will appreciate or depreciate at some point in the future. A CFD is a wager you make with your broker that your prediction will be the right one.
CFDs work when traders enter a contract with a broker to exchange the difference in price of an underlying asset at the end of the contract period. If the price goes up as the trader predicted, the trader makes a profit; while if the price goes down, the broker wins and the trader loses. CFDs are attractive because you can short an asset, meaning you can predict it will lose in value, so you can place a wager in both directions.
CFDs are a good trading method to use to trade with leverage, as you can gain exposure to a larger position than your initial investment. Another reason they can be attractive is because CFDs typically offer lower fees and commissions compared to other forms of trading, such as futures or options. This can help you keep your costs in check.
We’ll answer the same question about whether you need a broker to trade CFDs - you cannot trade CFDs without the help of a broker. This is because brokers provide the trading platform and act as intermediaries to help you access the financial markets. The broker acts as the counterparty to the CFD trade and sets the terms of the contract. The broker is in charge of placing a margin requirement and how much leverage you can utilize on the trade.
Comparing Stocks and CFDs
When comparing stocks and CFDs, a fundamental distinction lies in the aspect of ownership. Investing in stocks gives you direct ownership of a portion of the company. This ownership comes with specific rights. You can vote at shareholder meetings and you can even receive dividends if the company decides to distribute profits. This means that your profit or loss is directly tied to the performance of the company and the fluctuations in its stock price over time.
In contrast, CFDs operate on a leveraged, non-ownership model that allows you to speculate on the price movements of stocks without actually owning them. When we say that CFD trading is leveraged, we mean simply that it is a financial instrument where leverage is used extensively to expose traders to higher profits (but also higher potential losses). Unlike with stock ownership, you can’t vote at shareholder meetings and you don’t get dividends. As a CFD trader, you are not invested in the health of the company on which you are speculating. In truth, many CFD traders speculate that a particular stock will lose value! If the trader gets that prediction right, they benefit!
Advantages and Disadvantages of stock and CFD Trading
Each type of investing comes with its good and bad sides. We’ll explore them next.
The Pros and Cons of Stock Trading
Pros:
You can make good money: Stocks can provide the upside of high returns, particularly over the long term. Historically, stocks have offered higher returns than other investment options. The caveat is that you must manage your stock portfolio well.
Diversification: This is one of the mantras of the trading world – diversify! Every expert will tell you it is better to have a wide range of financial assets and trading strategies in your portfolio so you can protect yourself from losing money when one type of trading fails you. With stocks, you can diversify by investing in many different companies from different indices.
Liquidity: Shares are normally highly liquid, meaning they can be easily bought and sold on stock markets, allowing investors to quickly convert their holdings into liquid cash if needed.
Line of sight: Part of being a public company whose stock is traded on an open market is that it must be transparent about its performance. For this reason, publicly traded stocks are subject to regulation and oversight, giving you clear information you need to decide about whether to invest in a firm or not.
Opportunities for active trading: For those who enjoy active trading, like day traders and scalpers, stocks can offer many opportunities for short-term gains through buying and selling based on market fluctuations and breaking news.
Cons:
Markets can be volatile: Stock prices can be highly volatile, meaning that they can fluctuate rapidly and unpredictably in response to a range of factors, such as economic conditions, company news, or geopolitical events.
Company risks: Stocks are largely a reflection of how well or badly a company is doing and how investors feel about the prospects of its products and services now and into the future. Thus, share-price performance can be influenced by internal factors, such as management and product updates.
High risks: stock trading comes with no small amount of risk. You are constantly on a high wire balancing the risks posed by high leverage, volatility, and potential losses exceeding the initial investment. For example, Facebook’s parent company, Meta, in 2022 lost significant share value after announcing its new venture, the Metaverse, as investors were unconvinced by the viability of the idea.
Complexity: Investing in stocks requires you to work on your knowledge and understanding of financial markets. This typically requires time and effort to research companies and stay on top of market news.
No guarantees: Investing in stocks, like any financial instrument, involves risk. No person or institution can guarantee that you will make a profit. Stock prices can also drop quickly, sometimes causing significant losses for investors.
These benefits and drawbacks do not apply exactly equally to all investors. The risks will vary depending on an individual's financial goals, risk tolerance, and investment strategy. As with any investment, it's important to do your research, diversify your portfolio, and investigate the field as much as you can.
The Pros and Cons of CFD Trading
Pros:
Short-selling: As a CFD trader, you can make money not only when assets gain value, but also when they lose value, giving you twice the opportunity to earn. If you were interested in stocks, and you knew that a company stock price was about to drop because of adverse company news, you could easily short-sell that stock as a CFD.
Leverage: You can earn higher returns with leverage. Even if you have very little capital, trading on leverage gives you access to much larger positions than you would have without leverage, which means that you can potentially earn higher returns.
Diversification: This is one of the mantras of the trading world – diversify! Every expert will tell you it is better to have a wide range of financial assets and trading strategies in your portfolio so you can protect yourself from losing money when one type of trading fails you. With CFDs, you can trade on a wide range of financial markets, including FOREX, stocks, indices, commodities and cryptocurrencies.
Cons:
High risks: CFD trading comes with no small amount of risk. You are constantly on a high wire, balancing the risks posed by high leverage, volatility, and potential losses exceeding the initial investment.
Counterparty risk: Traders are exposed to the credit risk of their broker. If you do not choose your broker well, you could find yourself in a situation where you assume the counterparty risk if your broker goes insolvent.
Complexity: CFD trading is not ideal for newbies. You should ideally be conversant with the markets before you start with CFDs. Depending on where they operate, many brokers must voluntarily disclose on their platforms that CFD trading is especially risky and that traders could lose money easily.
In summary, both stock and CFD trading have their unique advantages and disadvantages. Stock trading offers the benefits of ownership, dividends, and long-term growth potential, but with limited leverage and higher costs. CFD trading offers high leverage, flexibility in market access, and the ability to profit from market downturns, but comes with high risk, potential for significant losses, and costs associated with leverage and financing.
Regulations Around Stock and CFD Trading
Stock trading is a long-established practice that is legal in all major markets. One notable exception for Shariah traders is that they are not allowed to purchase the shares of companies that engage in haram activities, such as alcohol production or gambling.
As far as regulation goes, all brokers must be regulated by a major oversight body. Some common regulators include the Financial Conduct Authority (FCA) in the UK, while in Cyprus brokers are regulated by the Cyprus Securities and Exchange Commission (CySEC). Australia has the Australian Securities and Investments Commission (ASIC) and US brokers are under the control of the Securities and Exchange Commission (SEC).
CFD trading is perfectly legal in many markets around the world. However, not all countries treat it the same, with some implementing more strict rules than others. Certain countries restrict how much leverage brokers can offer for CFD trading. Other countries, such as the U.S., have outright bans on CFD trading.
Some European countries have firm restrictions on CFD trading. CFD trading in Europe is regulated by the European Securities and Markets Authority (ESMA), which has imposed restrictions on the marketing and sale of CFDs to retail investors in the EU since August 2018. European traders will find that they must abide by such CFD trading guidelines as:
Leverage limits: Traders do not have access to unlimited leverage. For example, in Europe, leverage on individual equities is capped at 5:1.
Negative balance protection: Brokers that provide CFD trading must ensure that clients cannot lose more than their account balance.
Margin close-out: According to this rule, brokers must freeze a client's position when the client’s funds drop below a certain percentage of the margin required to maintain their open positions.
Marketing and distribution: European brokers must be alert to hold back from encouraging trading via bonuses and promotions, and they are obliged to post clear warnings about the dangers of CFDs, such as their high leverage, volatility, and the potential for trader losses exceeding the initial investment.
Risks and Considerations
Each type of trading comes with its risks and considerations. We discuss them here.
What are the Risks of Stock Trading?
Market volatility: Share prices often shift rapidly in light of breaking news or market developments. If traders do not watch their positions closely, they can suffer significant losses. Alternatively, they could also benefit from serious gains.
Company performance: Management changes, product failures, or regulatory changes: each of these factors can result in a decline in the value of the stock.
Liquidity risk: Even though stocks are mostly liquid, there may be times when a stock is hard to sell due to low trading volumes or market conditions, especially when the stock market is spooked and there are few buyers.
Currency and exchange-rate risk: If you invest in stocks that are traded in a foreign currency, you may be exposed to fluctuations in exchange rates, which can affect the value of your investment.
Inflation risk: As we are seeing in present economic conditions, inflation can quickly erode the value of your investment over time, meaning that the purchasing power of your returns may be limited.
Regulatory risk: Stocks are highly regulated in some countries, as we have shown. There is a risk of companies getting things wrong and being punished by a regulator.
What Are the Risks of CFD Trading?
Complexity: CFD trading is not a simple form of trading. It typically involves many considerations, such as how to apply viable trading strategies to volatile and fast-moving markets. Traders can easily lose money.
Market volatility: CFD prices often shift rapidly in light of breaking news events or market developments. If traders do not watch their positions closely, they can suffer significant losses. Alternatively, they could also benefit from serious gains.
High leverage: Most investors trade on margin when entering CFD contracts as they want to expose themselves to larger positions than their capital allows. The danger of this is that losses can exceed the initial investment if a trader makes a bad move. Even a leverage level of 5:1, in the wrong hands, can be damaging.
Counterparty risk: Brokers act as counterparties with CFD contracts, and traders are naturally exposed to the credit risk of their broker. Many brokers have become insolvent while their customers have open trades. In these instances, the trader stands to lose all their money if there is no compensation scheme in place.
Regulatory risk: CFDs are highly regulated in some countries, as we have noted. There is a risk to getting things wrong and being punished by a regulator.
What are the Best Strategies for Trading Stocks and CFDs?
The common strategies for trading stocks and CFDs are remarkably similar. Fundamentally, investors in both types of instruments are watching the same securities. You could be a stock trader watching the latest earnings release by Meta, and as a CFD trader, you would be watching Meta’s earnings release, too. It’s no surprise that the trading strategies are interchangeable.
Every trader’s stock strategy is different. That said, here are the most popular trading styles that are commonly used in stock trading and CFD trading alike:
Scalping: With scalping, you hold positions open for a brief time, as little as a few seconds to a few minutes. The intention is to profit from fractionally small price movements.
Trend-following: With this strategy, traders identify trends in the market and try to understand the direction of the trend. Using technical indicators, like moving averages, trendlines, or relative strength index (RSI), you can make money from trends.
Breakout: Skilled traders can come to understand when asset prices break through key support (lower) or resistance (upper) levels. Using common technical indicators, such as Bollinger Bands, traders can identify breakouts to help them set trades.
Swing trading: If you prefer a gentler trading pace, swing trading could be for you. With this type of trading, you would hold an asset for a few days to several weeks, depending on the strength of the trend.
News trading: The world is awash with news alerts and breaking market information. Some sensitive financial assets, such as cryptocurrencies, typically respond to good or bad market news. If you learn how to craft a winning strategy around economic releases, company earnings, or geopolitical events, you could do well with this type of trading.
It is vital to select a strategy that suits your trading style, risk tolerance, and market conditions. You must have a clear understanding of entry and exit points, risk management, and position sizing before you start to trade.
Which Instrument is Right For You?
Choosing between stocks and CFDs as trading instruments involves careful consideration. Here’s a structured approach to making this decision:
Define Your Trading Goals
Short-term vs. long-term: If your objective is to capitalize on short-term price movements and you're comfortable with higher risk levels, CFDs might be more appropriate due to their leverage and the ability to go short easily. For long-term wealth building, focusing on capital growth, and dividend income, stocks are probably the way to go.
Speculation vs. investment: Are you trying to profit from stock prices or are you in it to gain ownership in a company you like in order to meaningfully participate in its future? Determine if your aim is speculation or investment. CFDs are speculative instruments, while stocks are investment vehicles.
Assess Your Risk Tolerance
Leverage risk: CFDs offer leverage, which can magnify both profits and losses. If you have a high risk tolerance and are prepared to closely monitor positions and potentially lose more than your initial investment, CFDs could be attractive. Conversely, if you prefer a lower-risk profile, stocks may be more suitable as they do not inherently come with amplified risks from leverage.
Market volatility: Consider how comfortable you are with volatile market conditions. CFDs can offer more opportunities in volatile markets due to the flexibility of short selling and leveraging. However, this also means higher risk, which may not be suitable for every trader.
Consider Your Market Knowledge and Experience
Understanding leverage: Using leverage safely and effectively requires understanding of its mechanics and risks. If you're new to trading or uncomfortable with complex financial instruments, starting with stock trading might be advisable to grow your market knowledge and experience.
Technical vs. fundamental analysis: CFD trading often relies more heavily on technical analysis due to its short-term nature, whereas stock investments might be based more on fundamental analysis to evaluate long-term company performance. Are you proficient in carrying out a deep technical analysis of a stock? If not, fundamental analysis, a more general type of analysis, might be for you.
Evaluate Trading Costs and Accessibility
Costs: CFD trading might involve overnight financing charges (for holding positions open over a period), while stock trading could come with brokerage fees and taxes. Assess which cost structure aligns better with your trading strategy.
Accessibility: CFDs allow access to a broader range of markets, often beyond what's available to individual stock traders, including international markets, commodities, and indices. If diverse market access is crucial for your strategy, CFDs could be your best bet.
Incorporate Diversification and Risk Management Strategies
Regardless of the choice between stocks and CFDs, incorporating diversification across different asset classes and sectors can mitigate your exposure to risk. Additionally, employing risk management strategies, such as stop-loss orders, can help protect your investment.
Choosing between stocks and CFDs depends on how the instrument aligns with your financial goals, risk tolerance, market knowledge, and the specifics of your trading strategy. It’s also advisable to start with a demo account to familiarize yourself with the dynamics of your chosen instrument before committing real capital.
What Features Should a Good Stock Broker Offer?
When choosing a broker for online trading, be it a stock broker or a CFD broker, there are several elements to consider. Bear in mind that many brokers offer both stock trading and CFD trading. It is rare to find a CFD broker that does not offer access to stock ownership. Of course, you will find instances where a stock broker does not offer CFD trading, such as in the U.S.
So, the brokers you are assessing often offer access to both instruments. What are the broker’s educational offerings – such as articles, videos, and webinars? Intermediate and advanced traders will want a robust trading platform and a full suite of options-specific trading tools and resources. What is the quality of the mobile app? All these elements must be considered beyond the usual items that set online brokers apart from each other, like fees, trading platform strength, security, and speed of trade execution.
Although there are slight changes between what a stock broker and a CFD broker offer, there are a lot of common areas for which you should be on the look out. The best brokers strive to create a full-service offering that includes access to several different account types for traders of every level, rapid execution speeds, and detailed market insights and analysis. Traders also want access to the most competitive liquidity providers and charts that are easy to read and from which to trade. Here are some other key functions a good stock broker and a good CFD broker should offer:
Regulation: A good stock broker and CFD broker should be regulated by a reputable financial authority to ensure they operate in a fair and transparent manner.
Asset selection: The best brokers that offer access to stocks and CFDs should offer a wide range of asset classes on which trade, including FOREX, stocks, CFDs, indices, commodities, and cryptocurrencies, with a variety of instruments and contracts available for each. This is useful for when you want to diversify.
Low fees and commissions: Brokers that offer both types of instruments should offer competitive pricing and low fees and commissions to help traders keep their costs down and maximize their profits. It is common to find a lot of variability among fee levels at different brokers. As a new trader, be sure to keep your eye on fee levels.
Non-trading fees: You will run into fees at selected brokers even if you don't trade. A typical instance is when your account has been inactive. These so-called inactivity fees can start to bite if you have not chosen your broker well.
Education and analysis: A good broker in general should provide detailed educational resources and market analysis to help traders improve their trading skills and make data-driven trading decisions.
Risk-management tools: A good stock and CFD broker should provide risk-management tools. such as stop-loss and take-profit orders, as well as margin requirements and other measures to help traders manage their risk and protect their capital
Available stock assets: The best stock and CFD brokers should provide you with a wide range of stock exchanges on which to trade. The quality and variety of these exchanges are important as many traders take a global approach and require access to bourses around the globe.
Conclusion
Both stock trading and CFD trading can be highly lucrative trading styles. Trading in stocks has always been an attractive investment pursuit, and there has also never been a better time to be a CFD trader as brokers all over the world support this trading style. Yes, there are certain geographical limitations and some regulators have placed major guardrails around CFD trading, but if it is an option in your trading jurisdiction, it can be a powerful way to trade and make money.
Don’t forget that for all their pros, stock trading and CFD trading are both associated with some significant cons, such as the ability to lose a lot of money very quickly. CFD trading, in particular, comes with the dangers of high leverage. However, if you do your research ahead of time and enter the market with strong risk-management strategies, you have a chance of being successful.
With ever-improving technology, trading stocks and CFDs online is becoming a much more rewarding activity. Many of the top online brokers are long-established, well-regulated brokers that are always trying to improve their products and the trading experience of their clients.
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