Many investors when considering the pros and cons of CFD trading tend to compare it to spread betting, however, a more suitable benchmark for comparison is traditional share dealing.
While CFD trading and spread betting do have numerous similarities, it can be a more useful exercise to compare CFDs with the buying and selling of shares when deciding whether or not it is for you.
At this point, it is important to note that CFD trading and traditional share dealing are not mutually exclusive. Many traders include both as part of a diverse portfolio. So if after learning the risks and benefits of these instruments you find them appealing, there is nothing stopping you trading CFDs and share dealing simultaneously. However, CFD trading carries a high level of risk to your capital and you can quickly lose more than your initial investment. CFDs are not suitable for everyone and it is important you understand the risks involved and seek independent financial advice if necessary.
Below, we compare the two and highlight the pros and cons associated with each.
How do CFD trading and traditional share dealing work?
Share dealing is a concept many people are familiar with.
When you buy shares, you are directly investing in a company, meaning you have a direct share in the ownership of that company.
Shares can take two forms - ordinary or preference - and it is important that you explore the differences between the two.
You can buy and sell shares yourself through an online share dealing account or go through a broker however bear in mind that the value of investments can fall as well as rise and any income from them is not guaranteed. You should be prepared to lose your investment.
CFD trading, on the other hand, involves entering into a contract speculating on the movement of an asset price. It could be the price movement of a share, a commodity or other underlying instrument.
Essentially, a CFD - or contract for difference - is an agreement between you and the broker to settle at the close of the contract, the difference between the opening and closing prices of that contract.
What are the main differences between the two?
There are a number of similarities and differences between traditional share dealing and CFD trading.
The biggest difference between the two involves leverage.
Leverage is a concept that you must understand if you are to enter into CFDs, as it is a double-edged sword.
CFDs are traded on margin, meaning you can pay just a fraction of the total trade value. This allows you to enter into large trades with relatively little capital, therefore giving you the potential for huge profits.
At the same time, there is also the potential to make substantial losses, as leverage works both ways.
Another crucial difference is that with CFD trading, you never actually own the underlying asset. Instead, you simply speculate on which way its price will move. While this means you have no voting rights with regards to the company's future, CFD's do not incur stamp duty, so there are certain financial benefits.
Also, CFDs can be traded long or short, meaning there is the potential to make money in rising and falling markets.
Which is the better option?
There is no straightforward answer to this question and a lot depends on your appetite for risk.
CFDs are leveraged products meaning you can quickly lose more than your initial investment. At the same time, leverage can potentially deliver huge profits if you make the right call.
On the other hand, traditional share dealing is perhaps the easier concept to understand for novice investors.
In conclusion, both CFD trading and traditional share trading have their upsides and downsides and it is important that you explore these when deciding between the two. It is also a good idea to seek independent financial advice.