If you’ve been trading stocks for awhile and would like to find out if CFD trading could suit your trading style… this article is for you!
CFD trading is very similar to shares trading except that when you trade a contract for difference, you don’t own the underlying share. What you are buying is a contract between you and the broker.
The main difference between trading a CFD and buying a stock lies in the leverage.
When you buy a stock from the SGX, you pay for the full market value of the stocks. In contrast, CFDs are traded on margin, which means it allows you to trade from margin requirements from as low as 5 to 10%.
This allows you to make your trading capital work harder for you by opening larger position or free up money for diversification.
Another key difference is that you are allowed to short-sell CFDs.
In stocks trading, investors typically try to buy low and sell high, striving to earn a profit in an upward trending market.
However when the stock market is on a declining trend, you might have little option other than wait for the next window of opportunity.
This is where CFD trading makes perfect sense; you can choose to short the market and buy back the contract later in a bear market.
What Are The Advantages Of Trading CFDs?
- Leverage – With the same amount of money, you can trade some 20 times more CFD compared to buying shares. This is ones of the greatest advantage of CFD trading.
- Short the Market – Ability to go short when there’s a declining trend means you have more trading opportunities compared to the traditional shares market where you can only buy and profit from rising prices.
- Wider markets – most CFD providers allow you to trade not just local shares CFDs, but also provide access to foreign markets, as well as commodities.
- Execute more advanced strategies – with CFD trading, you can use more advanced strategies such as hedging and pairs trading.
Pairs trading is a trading strategy that uses a short position and long position of two different stocks in the same sector simultaneously.
The trick here is to short sell the outperforming stock while buying the underperforming stock, in anticipation that the spread in between the two will converge.
If the investor already holds the physical stocks to a company and the markets move down, he can short its CFD derivative to reduce his losses.
What Are The Risks Involved?
Obviously, CFD trading is like any other type of trading and comes with its fair share of risks:
- CFD trading is not as transparent as stocks trading – CFD is an Over-The-Counter (OTC) product, which means that it is less transparent compared to trading through an exchange.
This can mean all sorts of issues, ranging from having difficulty in knowing who you are trading against and whether you are being charged and offered a fair price.
In fact, your CFD provider might very well be the counterparty to your trade, who aims to profit from your losses.
- Leverage is a double-edged sword – the means to trade on margin also means a small market movements can have a big impact on the profit and losses of your trades.
- Deposit requirements – to hold a CFD position, you need to have enough money in your account to cover the margin requirement.
If your position goes into losses, you will receive a margin call from your broker and you will need additional funds to top up your account.
While CFD trading and stocks trading share a fair amount of similarity, the main difference being that CFD relies on margin trading. It will result in a huge difference for someone with a lower threshold of risk.
Assess your risk appetite and trading knowledge before you take the plunge to trade CFDs.
Without pointing out the obvious, benefits of trading CFDs versus stock trading are very clear:
- Zero Brokerage
- Access to the top 200 ASX Shares
- 5% margin or up to 20 times leverage
- Free trading platform
Unfortunately for traders, the zero brokerage whilst trading CFDs didn’t last that long.
Nowadays the common brokerage levels for CFD brokers is around 0.08% and as low as $7 minimums.
Advantages Of CFD Trading Versus Stock Trading
- Low trading costs
- Overnight CFD financing is not a factor if holding positions for less than 40 – 90 days
- Greater access to opportunities through leveraging your trading dollars
- Some CFD brokers allow you to trade the full complement of ASX listed stocks
- Access to dividends
- Short selling is available on top 200+ ASX share CFDs
- Guaranteed stops readily available from most CFD providers
Disadvantages Of CFD Trading Versus Stock Trading
- Overnight financing will become a factor if holding share trades for more than 40-90 days
- Most CFD providers only give you access to the top 500 ASX listed stocks
- No franking credits on dividends received
So Is Stock Trading Or CFD Trading The Way To Go?
By means of capital, it will help answer your question:
If you have little trading capital (from $1,000 to $10,000) then your choices for stock trading can be somewhat limited. The reasons for this are pretty straight forward.
If you make a $2,000 trade with someone like Etrade, where your share brokerage is $65.90 incl GST (as of writing) for a complete trade, it will eat significantly into your trading profits.
Just to break even, your $2,000 position has to go up 3.30%. Now that may not seem a lot initially but what if you are doing a number of trades in a month? Each position now has to gain 3.30% just to break even.