Introduced first in the early 1990s mainly for institutions and hedge funds, stock CFDs (Contract for Differences) have since spread globally to become one of the most traded products on brokerage platforms.
Stock CFDs have particularly gained traction within the retail market as they enable small traders to gain access to some of the biggest companies in the world, including Nvidia, Apple, Alphabet, Microsoft, and others. This article explores how stock CFDs work and when to use them in trading over regular stocks.
Understanding Stock CFDs
Stock CFDs enable investors to profit from price movements of stocks without owning the shares of the underlying asset. A stock CFD is an agreement between the investor and the broker to exchange the value of the stock from the time a trade is opened until it closes.
CFDs allow investors to capitalise on leverage, in which case investing $100 at 10x leverage allows the investor to control $1000 in capital.
For instance, a trader can profit 20% from the Nvidia stock price movement by placing a sell order followed by a stock price movement to $176.4 from $180. With 10x leverage, the trader earns $36 from that trade.
Short/sell positions profit when the price moves downwards, while long/buy positions profit when the price rises.
Similarly, a move in the opposite direction to your position can result in bigger losses, which is one of the main risks of trading stock CFDs compared to regular stock investing.
Important Aspects of Stock CFDs
Leverage is one of the biggest changes when it comes to trading CFDs versus regular stocks. It amplifies the investor’s spending potential, enabling them to make significant profits from small capital commitments. For instance, a trader’s account of $1000 can control a capital of $10,000 with 10x leverage.
Dividend adjustment is another key aspect of stock CFDs. Qualifying long positions (those that remain open before the stock goes ex-dividend) are credited with the equivalent amount, while qualifying short positions are debited. Therefore, it is important to pay attention to company dividend dates just as a regular investor would.
Volatility plays a big part in stock CFDs, enabling traders to profit from either side of the trade. However, because of leverage, high volatility can cause huge losses on open positions, especially when slippage occurs. While profits are great when using CFDs to trade, losses can be catastrophic. Data shows that up to 70% of CFD traders lose money.
Why Trading Stock CFDs Over Regular Stocks
Stock CFDs have revolutionized the stock market, with regular forex brokerage platforms, which are easily accessible, bringing in a class of investors who previously couldn’t access the market.
If you have limited capital, then trading stock CFDs would likely be your preferred option to regular stocks if you wanted to invest in the big blue-chip companies.
However, because you’ll probably be using CFD forex brokerage platforms where liquidity isn’t as high as when using exchanges like, say, Nasdaq, it is important to choose your trading sessions carefully. The busiest sessions, like the New York session, 9 am to 5 pm, would be best.
It is also important to have a well-defined strategy if you plan on trading CFD stocks. For instance, choose whether your strategy involves leaving trades open overnight or if all positions must be closed before the close of the day. Overnight trades attract more charges, which can further affect your profit-earning potential.
Conclusion
Stock CFDs allow small retail investors to profit from some of the biggest companies without committing too much capital. For instance, some CFD forex brokers allow investors to start trading with as little as $1,000, giving them leverage of up to 10x on stocks. Traditional brokers may ask for a higher opening balance.
It is advisable to choose a leverage of 3x-5x if you want to minimise the impact of losing trades on your portfolio. Also, make sure to leverage the risk management tools provided by brokers, including stop loss and trailing stops, and take profit limits in your trades.
