CFDs vs investing: what’s the difference?
City Index March 3, 2021 1:54 AM
CFD (Contract for Difference) trading and investing are popular methods of getting involved in financial markets. This article will discuss the differences between investing and CFDs, as well as each product’s unique features and benefits.
- What is the difference between CFD trading and investing?
- CFD trading versus share dealing, which is best for me?
- How to start CFD trading
What is the difference between CFD trading and investing?
CFD trading and investing are two separate ways to take a position on an asset’s price movements. The main difference between them is that with CFDs, you don’t purchase the underlying asset, whereas investors take ownership of the financial product.
Because you don’t purchase any assets, CFDs are free from stamp duty – although capital gains tax is due on any profits.*
CFDs are often popular among active traders. Investors, on the other hand, are mostly passive. Investing often involves buying and holding assets for months or years, looking for longer-term returns. In contrast, some CFD traders might try to avoid keeping any positions open for longer than a single day.
However, you can use CFDs to target longer-term returns on your trading platform, by holding a long position for weeks, months or even years.
As well as tax, CFDs come with three key advantages over investing: leverage, going short and the range of available markets.
One of CFD trading’s main benefits is the ability to use leverage, giving you full market exposure while only committing a deposit upfront.
With leverage, for example, you might only be required to make a margin deposit as low as 5% to execute certain transactions.
Despite only putting down 5% of your position’s total value, your profit or loss is still based on its full size. So you can earn 100% of a transaction’s gains – or losses.
Leverage is not available when you directly invest in shares; you must pay the position’s full value upfront.
Going long and short
If you trade CFDs, you can go long (buy) or short (sell) a market. Shorting gives you a position that will profit if the underlying asset price falls instead of rising. It can be a useful method of targeting returns in bearish conditions.
Whether you’re bullish or bearish, the process involved is the same. You make your market direction prediction and place the trade through your platform.
In contrast, if you’re a typical retail shares investor, shorting the markets can be a complicated process requiring borrowing then reselling stocks. This complexity is why investors tend to concentrate on buying with the anticipation that an investment’s price will rise over time.
What can I trade?
When you trade CFDs, you can deal in a vast range of financial products: forex, commodities, equity indices, shares, and more. Investors tend to concentrate their attention on share and asset investing only by engaging in a buy and hold strategy.
With City Index, for example, you can use CFDs to trade over 12,000 global markets. Using a single platform, you can take your position on EUR/USD, Apple, the FTSE 100, gold and much more. To see our full range of markets, open a demo account.
CFD trading v share dealing, which is best for me?
Share CFDs and share dealing are two methods to speculate on financial markets. Through a process of elimination, you can decide which option is best for you.
CFDs might be for you if you want:
- Access to over 12,000+ markets, including forex, commodities, indices, shares and more
- To trade on leverage
- The option to go short as well as long
- To save on stamp duty*
Share dealing might be for you if you:
- Are happy sticking to global stocks and ETFs
- Are comfortable committing to the full value of the position upfront
- Want to take ownership of the asset
CFD vs investing example
ABC plc company is trading at a sell/buy price of 130p/132p.
CFD trading ABC
You buy 1,000 share CFDs because you think their price will rise.
The CFD for ABC has a margin rate of 5%; you must deposit 5% of the position’s value as collateral. In this example, your CFD position margin is £66 (5% x 1,000 units x 132p buy price).
Your prediction proves to be right. ABC stock rises during the New York session to a sell/buy price of 137p/139p. You close your position by selling at 137 (the new sell price).
The price has moved 5 points (132 to 137) in your favour. Multiplied by your position’s size (1,000 units), your gross profit is £50.00.
Your total profit on your ABC trade is your gross profit minus total commissions.
If ABC had fallen 5 points
Investing in ABC
You buy 1000 ABC shares because you think their price will rise.
You’re investing, so you need to buy the shares outright. To buy 1,000 shares in company ABC, you’d need £1320.
If ABC hits 137/139p, then you can sell your shares for £1370, earning you a £50 gross profit.
Again, your total profit would be £50 minus any commissions or broker fees.
How to start CFD trading
- Open a live account to trade CFDs with real funds or use a demo account to develop your skills and get familiar with the platform
- Choose the CFD instrument you want to trade, like GBP/USD or the UK 100
- Decide how many CFD units you want to trade. The value of one CFD unit can vary depending on the instrument
- You buy (go long) if you think the price will rise or sell (go short) if you believe it will fall.
- After executing your trade, monitor your open position – and consider adding a stop-loss and a take-profit order
- If your trade does not automatically close due to a stop or take-profit order getting hit, you can manually exit your position
Can you lose more than you invest in a CFD?
Retail client accounts have negative balance protection; losses are limited to the value of the funds in your account.
For example, if you execute a CFD trade worth £500 and the margin rate is 5%, you’re required to deposit £25 to open the trade. In this situation, you have only deposited £25, so you can't lose any more than that due to the 50% margin requirement unless you add more funds.
Can I vote if I trade a CFD?
You do not get voting rights in the company if you trade a CFD. The CFD is a derivative of the underlying asset, not the investment. You only get voting rights if you invest (own shares) in the company.
Is it better to use CFDs or invest?
Both products and market access have unique features and benefits, and your circumstances and goals are equally individual. Perhaps using the points raised in this article will assist your decision making.
* Spread Betting and CFD Trading are exempt from UK stamp duty. Spread betting is also exempt from UK Capital Gains Tax. However, tax laws are subject to change and depend on individual circumstances. Please seek independent advice if necessary.
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