This article was written by Christian Borjón Valencia (Tradepedia for XM.com).
Trading and investing have become increasingly accessible
to the general public, mainly due to the availability of online platforms. This
has led to the development of innovative financial instruments, notably
Contracts for Difference (CFDs) and traditional stock investments. While both
can generate capital gains from asset price fluctuations, they have significant
differences, advantages, and associated risks. Let’s take a closer look at
them.
What Are CFDs?
Contracts for Difference (CFDs) are financial derivatives
that allow traders to speculate on the price movements of underlying assets
without actually owning them. For example, one can buy a CFD on a company like
Apple and profit from the difference between the buying and selling price.
However, if the company reports profits and pays dividends, CFD holders are not
entitled to this benefit, which is exclusive to stock market investors.
When an investor chooses to trade CFDs, they enter into a
contract with a broker agreeing to exchange the difference between the opening
and closing price of the contract. CFDs cover a wide range of assets, including
indices, stocks, commodities, and currencies.
What Is the Stock Market?
On the other hand, the stock market involves purchasing and
holding shares of a company, granting investors shareholder rights. Some of the
benefits of stock ownership include receiving dividends and, in certain cases,
having voting power in corporate decisions.
Differences Between CFDs and Stocks
- Asset
Ownership: - CFDs:
The trader does not own the underlying asset but speculates on its price
movements and earns capital gains in cash. - Stocks:
The trader legally owns the purchased shares. - Leverage:
- CFDs:
Brokers offer leverage, allowing traders to increase their buying power
by trading with borrowed capital, amplifying both gains and losses. - Stocks:
Generally, stocks are not leveraged, and the available capital is limited
to the investor’s deposited funds. - Costs
and Commissions: - CFDs:
They have variable spreads and additional costs, such as swaps (interest
for holding positions overnight) if positions remain open for multiple
days. - Stocks:
Typically, investors pay fixed or percentage-based commissions per trade,
but long-term holdings do not incur interest charges. - Dividends:
- CFDs:
Since CFD holders do not own the underlying asset, they are not entitled
to dividends. - Stocks:
Shareholders receive dividends directly, potentially increasing long-term
profitability.
Advantages and Disadvantages of CFDs
Advantages:
- Access to
multiple markets with a small capital investment. - Ability to
trade both rising and falling markets. - Offers
flexibility and fast execution.
Disadvantages:
- Higher
risk due to leverage. - Potential
losses exceeding the initial investment. - Additional
costs if positions are held for several days.
Advantages and Disadvantages of the Stock Market
Advantages:
- Lower
risk, as there is no leverage involved. - Rights to
dividends, stock splits, and corporate benefits. - Ideal for
long-term investment since there are no swap fees.
Disadvantages:
- Higher
initial capital required for significant investments. - Limited
opportunities to profit in bear markets, except through additional
derivative instruments or the “uptick rule.” - Less
flexibility compared to CFDs.
Conclusion
As an investor, it is essential to evaluate all these
factors. Since most retail traders do not have large amounts of capital, CFDs
provide an advantage by offering leverage. Additionally, CFDs grant access to
various markets, allowing investors to diversify their portfolios with indices,
commodities, currencies, and stocks.
This article was written by FL Contributors at www.forexlive.com. Education Read More