Choosing between CFDs and stocks is not just about picking an asset; it’s about understanding your strategy, risk tolerance, and financial goals to unlock your true trading potential.

Have you ever wondered what the difference between CFDs and traditional stocks is? Both are popular financial instruments that give you access to the stock market. They both allow you to take advantage of the price changes in company stocks from around the world and they both carry the risk of loss as the market can go against you.

But in what ways are they different? And how can you know which is best for you? In this article, we outline how each of these trading methods work, and the key differences between them to help you decide.

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How Does CFD Trading Work?

A Contract for Difference (CFD) is a financial derivative that enables you to trade the price movements of various assets, including stocks, without owning the underlying securities.

CFD trading allows you to profit from both rising and falling prices of the assets you trade. You can do that by opening a long (buy) position when you believe that the price of an asset will increase, and opening a short (sell) position when you believe that it will decrease. In either case, you agree to exchange the difference between the price when opening the trade and the price when closing the trade.

It also allows you to trade with leverage which is a loan you take from your broker to hold a larger position with a smaller amount of capital. Holding a larger position means that the profits or losses you make from the price movements will also be larger, introducing both the possibility of greater rewards and the risk of greater losses.

How Does Stock Trading Work?

Traditional stock trading involves buying a company’s shares with the goal of making a profit by selling them at a higher price. In stock trading, when you buy the shares of a company, you own the underlying securities and you have shareholder rights. This means that you can potentially profit from earning dividends on your shares as well.

Traditional stock traders will generally aim to profit from price appreciation, where the value of the shares they buy increases over time. Though they can also profit from falling prices by short selling, it is a more complex and less common process.

Unlike CFD trading, traditional stock trading typically requires full payment for the shares and does not involve borrowing, which makes it a more straightforward investment approach focused on long-term growth and income.

How Are CFD Trading and Stock Trading Different?

Ownership of the Underlying Asset

As mentioned earlier, traditional stock trading involves owning the underlying shares.

CFD trading, on the other hand, is carried out without taking ownership of the assets traded, and by exchanging the price difference between the time the trade is opened and the time the trade is closed.

Time Horizon and Objectives

Given that you take direct ownership of a company in stock trading, your objectives are more likely to be long-term. You invest in companies when you have an overall positive outlook on their long-term value.

CFD trading, on the other hand, only focuses on the price difference between opening and closing a trade. It is therefore suitable for those who are interested in the short-term price movements of the assets traded.

Shareholder Rights

In traditional stock trading, you have a stake in the company whose shares you own, and depending on the corporate governance policies of the. companies you invest in, you are granted certain rights such as voting rights and dividend payments.

In CFD trading, you do not get any shareholder privileges, though you can profit from dividend adjustments that are given to offset the change in the share price.

The Use of Leverage

In CFD trading, it is possible to control larger positions with a smaller initial deposit thanks to the use of leverage. This amplifies the potential profits and losses you can make from your trades.

Traditional stock trading, on the other hand, typically does not involve leverage. You pay the full price for the shares you want to buy.

Short Selling

Unlike long positions where the goal is to buy an asset at a lower price and sell it at a higher price, short selling involves selling high and buying back at a lower price. Due to lack of ownership, short selling is more straightforward and more common when trading CFDs.

Going short is possible in stock trading as well. However, it is less straightforward as it would involve borrowing stocks from your broker. Additionally, it can bring about extra borrowing costs.

Hedging

Hedging is a risk management strategy used to offset potential losses by taking an opposite position in a related asset, thereby reducing the impact of adverse price movements. Given that CFD trading facilitates going short, CFDs make for useful assets in hedging strategies.

Trading Costs

CFD trading costs include spreads and overnight charges. Spread is the difference between the ask and the bid price of an asset, whereas overnight fees, otherwise known as swaps, apply when you leave a position open overnight.

There are no spreads or overnight fees in traditional stock trading. Rather, depending on your broker, you may be subject to commission fees, exchange fees, and custody fees.

Potential Losses

The possibility of loss is inevitable in all forms of trading and investing. When you trade stocks, the amount you have invested into buying your shares is the maximum amount you can lose. The share value would have to fall down to zero for that to happen.

In CFD trading, however, your losses can exceed your initial margin, as you can always add more funds to maintain your position. This is why it is imperative to closely monitor your positions after opening them.

Range of Markets

CFD trading gives you exposure not only to the stock market but to many other assets. These include commodities, forex, precious metals, and more.

In stock trading, you only deal with company shares and exchange-traded funds (ETFs).

Example of a CFD Trade vs. a Stock Trade

Let’s examine a hypothetical scenario to better illustrate the difference between trading a stock and a stock CFD. Imagine you want to invest in Amazon stock, which is currently trading at $100 per share.

CFD Trade Example

You decide to go long (buy) on 100 shares of Amazon stock using CFDs.

Since you have the possibility to use leverage in CFD trading, you only need to deposit a fraction of the total contract value, known as the margin requirement.

If we assume that the margin requirement for Amazon stock is 5%, you have to deposit $500 to control a position worth $10,000 (100 shares at $100 per share).

Now let us assume that the price of Amazon stock rises to $110 per share. You sell the contract back to the broker at the current market price, earning a profit of $10 per share ($110 – $100 = $10).

Your overall profit from the trade is $1,000 ($10 profit per share * 100 shares).

Stock Trade Example

You decide to buy 100 shares of Amazon stock.

The current price of the stock is $100 per share so you invest a total of $10,000 ($100 * 100 shares). At this point, you own the shares you bought, and you have access to certain shareholder privileges.

As in the CFD trading example, the price of Amazon stock rises to $110 per share. You decide to sell your shares at the current price, and you earn a profit of $10 per share ($110 – $100 = $10).

Your overall profit from the trade is $1,000 ($10 profit per share * 100 shares).

As you can see, the profit made from both the CFD trade and the stock trade is the same. However, the percentage of gains compared to the initial capital invested is different in each case.

CFD Trade Percentage of Gains

Remember that the amount of capital invested in the CFD example was $500. The profit made, therefore, is 200% of the initial capital ($1,000 * 100 / $500).

CFD Trade Outcome Summary

Stock Trade Percentage of Gains

In the stock trading example, we started with an investment of $10,000. The profit made, therefore, is 10% of the initial capital ($1,000 * 100 / 10,000).

Stock Trade Outcome Summary

CFDs vs. Stocks Comparison Table

CFD Trading Stock Trading
Ownership of Underlying Securities
No
Yes
Trading With Leverage
Yes, leverage is built in
Typically no
Short Selling
 Yes
Yes, but it is not as straightforward
Shareholder Rights
 No Yes
Dividend Payments
Yes, through dividend adjustments
 Yes
Trading Costs
Spreads and overnight charges
Brokerage commission fees
Potential Losses Can exceed the initial margin deposited if more funds are added Capped at the initial investment amount

How to Choose Between Stock CFDs and Traditional Stocks

Below are the factors to consider when choosing between the two:

Investment Goals

Are you a short-term trader or a long-term investor? Think about what your trading goals are to determine which path to follow.

CFD trading aligns more with short-term financial goals. It can provide larger returns in a shorter time frame thanks to borrowed funds enlarging profits from small market movements (although this also magnifies potential losses).

Conversely, if you wish to accumulate wealth in the long-term and prefer investing in established companies for dividend income and capital appreciation, traditional stock trading is the way to go.

Existing Capital

What about the amount of capital you can put into your investment?

It is worth noting that stock trading can require a higher investment than CFD trading. This is because you typically pay the total amount of the share price. You need to make sure that you have enough capital to spare for such ventures.

CFD trading, on the other hand, has leverage built in and therefore allows you to control larger positions with a smaller amount of capital. Please note that this comes with the risk of amplifying your potential loss as well, and thus, you should be careful with the leverage ratio you choose to trade with.

Risk Tolerance

When deciding between CFD and stock trading, it is worth asking yourself how much risk you can take.

CFDs are complex financial products and therefore bear higher risk. For instance, using leverage in your CFD trading means both your profits and losses are magnified. Additionally, losses can surpass your initial margin if you keep adding funds to maintain your position.

Stock trading, on the other hand, is lower in risk because there are generally no borrowed funds involved. You also cannot lose more than what you initially invest.

Experience and Knowledge

Since CFDs are complex financial products and hold high risk, it is crucial that you have a good understanding of the market dynamics, technical analysis, and risk management strategies.

However, this is not to say that you can engage in traditional stock trading without having any knowledge. Both trading methods are risky and should not be tried without having a good grasp of the factors involved.

At XM, we offer a wide range of free online resources such as our trading glossary, webinars, live sessions, and much more, to help you get started. You can also monitor the markets with our expert insights.

Make sure you use our free demo account to test your trading strategies before you trade with real funds.

Final Thoughts

Choosing between CFDs and stocks is not just about picking an asset; it’s about understanding your strategy, risk tolerance, and financial goals to unlock your true trading potential. Although CFD trading and traditional stock trading are similar in many respects, they have their unique advantages and risks. CFD trading facilitates the use of leverage and short selling, and aligns with short-term investment goals. Stock trading, on the other hand, is more suitable for long-term wealth accumulation and can offer ownership privileges. Consider your investment goals, risk tolerance, trading style, and experience level, before deciding on the method that is best for you.

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Frequently Asked Questions

1. Is CFD trading better than stock trading?

This depends on your individual preferences and investment objectives.

CFD trading offers leverage, flexibility, and the ability to profit from both rising and falling markets, although it comes with a higher risk due to the use of leverage. Traditional stock trading offers you ownership of the underlying assets, voting rights, and a longer-term investment horizon with mitigated risk.

You should carefully assess the pros and cons of each option and choose the approach that aligns best with your goals and style.

2. Are CFDs riskier than stocks?

Yes, CFD trading typically involves higher levels of risk compared to traditional stock trading. This is primarily due to the use of leverage, which can magnify both profits and losses.

However, although the risk in traditional stock trading is generally lower, there is still the risk of market volatility or company-specific and economic factors that can affect the stock market. Either way, it is essential to have effective risk management techniques in place to protect your capital.

3. Is CFD trading cheaper than stock trading?

Costs of trading usually depend on the brokerage platform you trade with and the fees they charge. For this reason, CFD trading is not necessarily cheaper than stock trading.

It can, however, be cost-effective because many CFD brokers offer competitive pricing with low commission fees nowadays. Some brokers, like XM, do not take any extra commissions.

Another way in which CFD trading can be cost-effective is through the possibility of opening leveraged positions. This means that a CFD trader would need a smaller amount of initial capital to have the same market exposure as a traditional stock trader. However, keep in mind that this also introduces the risk of greater loss.

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