CFD Trading Vs Stock Trading: How Does It Compare To Trading Stocks And Shares?
So which is better? Stocks or CFDs?
Well, there is no one clear cut answer, but there some differences between shares and CFDs that you should be aware of to see it CFD trading is suitable for you.
As well as advantages, there are disadvantages to CFD trading that you should be also aware of, so that if you can overcome them, then CFD trading may be a profitable trading instrument.
Firstly, let's have a look at the main reasons why CFDs are traded over stocks and shares on the stock market, as well as their disadvantages.
1. The use of leverage
With CFD brokers and providers, there is 10 to 1 or 20 to 1 leverage available. This means that you can magnify your returns by 10 fold or 20 fold. The advantage of this? You can make more profits with a smaller float. But leverage is a double edged sword.
The disadvantage of leverage is that if you do not have a good CFD system, have innapropriate trade sizes or use of leverage, then you can lose more than your float.
For example, if you buy $10 000 worth of CFDs using $1000 cash margin, and the stock CFD price goes down by a huge amount say 90% of its value and you haven't exited, then the loss is $9000, which is way bigger than your $1000 cash margin you've put up for just that one trade.
So your results are magnified, so you must trade with good money management.
And remember that you have a choice, you do not have to use all your leverage and max out your margin, you can use a specified or limited amount of leverage, as appropriate to your strategy and rules.
2. You can short more stocks when trading CFDs rather than stocks.
This means more buying and selling opportunity, so if your system is profitable over bullish as well as bearish markets, then you can take advantage of the market as it goes up or down.
Different CFD providers will have different number of stocks that are shortable. So find out from them which stocks or shares can be shorted.
Note that depending on market conditions that these lists may change over time.
3. Less commission costs
Typically, if you compare the $10 minimum CFD commission with a $20 share commission (some are even more), then the lower commissions of CFD can be appealing.
Take into account of course, the financing rates for holding on the long CFD commissions and the amounds paid for short positions.
So depending on the trading that you're doing, calculate the differences in commissions and see the differences.
Now let's have a look at the main disadvantages or limitations of CFD trading.
Leverage is already mentioned as a potential disadvantage, especially with innapropriate money management rules or lack of trading strateg.
Slippage can happen with both stocks and CFDs.
When dealing with a market maker type CFD provider, then you may have to deal with possible slippage. Even if you use DMA CFDs (Direct Market Access), but you trade illiquid stocks then you may get slippage due to the market: that is, not enough liquidity in the underlying stock to get out at the expected price.
This means that if the provider executes your stops in such a way that there is a bit of a delay getting out of a CFD via your stop loss (set at say $4.75), then instead of getting out at $4.75, you may have gotten out at $4.60, which means that you would've have gotten out with less profit than you expected. This is called slippage.
Sometimes a marginally profitable trade can become a losing trade due to slippage.
2. Spread widening
Market maker CFD brokers may widen the spread more than their usual small smounts of 0.05% or whatever amount they normally have in certain times of the day, so that when you get in or out of stocks, you may get a price that is different to the one you expected.
You just have to monitor your results with your trading. This is even more so if you trade relatively illiquid stocks. You may need another source of data and 'course of trades' (prices and volumes) to compare.
However, keep in mind that depending on the exit rules and entry tules of your provider (eg exit or enter if touched, irrespective of the volume in the underlyng market), then you may exit or enter a trade with less slippage than if trading in the underlying market, so this can overome the spread widening.
3. There are limitations to how much you can scale your trading up depending on the market.
With CFDs in a market with high liquidity, there is less liquidity issues with the majority of CFDs.
But if you're trying to put on large trade sizes in a CFD market that is relatively small, liquidity issues may cause it's own slippage.
This is an issue if you're trying to leverage larger positions in an illiquid market, so get an idea of the size of the markets you're dealing with and see if this is an issue for you.
And remmeber that with leverage that this can work for or against you, as it magnifies the results of your trading. So ensure that you have a good system that is profitable.
So, when trading CFDs, be aware of these pros and cons.
As with everything, there is probably no 'perfect' instument to trade.
But if you know what the pitfalls are, then you can overcome many of them to some extent by either redesigning your system or finding a different CFD provider.
All trading involves a high risk of financial loss, and the information on this site is for general information purposes only and is not financial advice in any form. Seek your own financial advice before taking any action.
All forms of trading involves risk of financial loss.
Also note that CFD trading is not legally permitted in some countries.
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