The Difference Between CFD Trading and Investing

CFD Trading: Meaning and Application

CFD stands for a contract for difference; it's a derivative product that allows you to trade the asset's price movements without owning it. The CFD's price is the price of the security you trade.

If you're familiar with Forex trading, CFD trading is similar. Traders open positions based on their price predictions and either make a profit or incur losses. CFD trading is available for a wide range of financial securities, such as stocks, commodities, indices, futures and more. 

How the CFD Market Works

The idea behind CFDs is that you can trade security without owning it. For instance, if you buy a commodity CFD for oil, you don't own barrels of crude oil. You can only potentially profit or lose funds from speculation on oil's price movement. So, you forecast a price direction based on fundamental and technical analysis and place a buy/sell order.

You buy or go long when you believe the asset's price will increase. You sell or go short if you're sure its price will decline.

When trading CFDs, it's worth knowing such vital terms as leverage, margin, spread and swap.

• Leverage. When investing, you need significant funds to purchase stocks, for instance. But when trading a stock CFD, you can start with $100 since CFDs are a leveraged instrument. As a reminder, leverage is the ratio of the amount you have to open a trade and the amount you use when opening a trade. Leverage raises the funds you can use to open a position. For instance, if the leverage is 1:100, you have $10,000 to open a trade vs $100 of your own funds.
• Margin. Another term you should be aware of is margin, which is the initial investment used to open a position.

You should remember about risks that are also applied to forex trading. Leverage and margin trading raises both the potential profit and the potential losses.

As with any similar financial endeavour, CFD trading includes expenses. Here are some terms that explain the expenses you bear when trading CFDs.

• Swap. When trading CFDs, you don't have to close your position within a day. Instead, you can keep it open as long as your funds allow you to. Still, you may have to pay an amount known as a swap to keep the position open. 
• Spread. This is the commission you pay to a broker for executing your trade. The spread is the difference between the ask and bid prices. 

CFD trading is done via brokers, so you can open a position either on MetaTrader or the broker's own trading platform.

Stock CFD Trading: Example

Although CFDs are available for various assets, we would like to focus on stock CFDs as shares are widely used both for trading and investing.

There are two options to trade stock CFDs: stocks and indices.

Company stocks. The first option is to trade a particular company's stock. Stocks offer a higher chance of moving in a certain direction and open a buy or sell trade (remember that when trading CFDs, you don't own the actual assets; you earn on price movements, so you can both buy and sell depending on market conditions). 

The choice of stocks depends on many factors. You should apply fundamental analysis, which includes financial results, internal company news, industry news, etc. Also, remember to use technical analysis, which includes indicators, chart and candlestick patterns, price volatility, etc.

Indices. The second option is stock indices. An index is a benchmark that reflects the price performance of several of the largest stocks listed on a certain exchange. Here, you get a chance to lower risks as indices are a less volatile financial product. Their direction depends on the price of all stocks included in them. So, if one stock skyrockets, the rise will be limited by the price movements of other stocks. 

When trading, there is no big difference between indices and real stocks. You may profit from both if you know how to predict a price direction. 

Benefits and Limitations of CFD Trading 

To understand this financial product better, it's worth considering its benefits and downsides. 

Investing: What It Is and How to Invest

An alternative to CFD trading is investing, which is the financial action of putting money in a financial product by acquiring it. There are many assets you can invest in, such as stocks, bonds, mutual funds, ETFs and more. The idea is to generate income from dividends or to sell it later when the price increases.

How to Invest

Because a wide range of securities is available for investing, it's impossible to highlight rules that apply to everything, but let's look at some examples.

A deposit in a bank account is one way to invest. You put your funds in an account and get monthly income through interest on your deposit. If you want to invest in bonds, you put your funds in them (at the time they're issued or on the secondary market via a broker) and get dividends for lending your funds to the company that issued the bonds.

In the next part, we'll consider ways of investing in stocks.

Investing in Stocks: Examples

There is also more than one option to invest in stocks. 

Real stocks

The first way is purchasing real stocks. You buy one or several shares of a company's stock and get dividends for them. You can purchase stocks either through a stockbroker or directly from the company (if available). This option is available for you if you own enough money to afford stocks at their real price. Real stocks can be used to diversify your portfolio. However, this form of investment may be expensive as real stocks have high prices.

Mutual funds and ETFs

Another way to invest in stocks is to purchase parts of different shares by investing in a mutual fund. ETFs and index funds are like mutual funds in that they track an index. You can combine several funds to diversify your portfolio.

Investing: Advantages and Disadvantages 

To compare CFD trading and investing, we should know the advantages and disadvantages of both concepts. 

Trading CFDs vs Investing in Stocks

To make it clearer, look at the table below that compares trading and investing. Although you can invest and trade many financial securities, we will compare stock CFD trading and stock investing. We'll highlight the similarities and differences. 

CFDs vs Investing: What Should You Choose?

There is no clear answer. You should choose the activity that matches your goals. If you have significant funds and are a passive investor, you can invest. If you're an active trader, CFD trading might be a good option, although it's riskier. Another feature of CFD trading is that you have more options to open trades because you can both buy and sell. 

If you don't have experience in CFD trading, you can open a Libertex demo account. It resembles a real account but allows you to trade without losses and gain experience. Please remember that it's not a real account, so there are no losses or profits. 

Let's summarise what we've covered.