Ever since contracts for difference (CFDs) came into being a few years ago, traders have been asking which should I use? Should I carry on trading shares as I always used to, or is there any advantage switching to CFDs in certain circumstances?
As with many questions, the answers aren't totally straightforward, and you have to weigh up the pros and cons of each method of trading. On balance, switching to CFDs has worked out for many active traders, but it depends on your capitalization and your trading style.
Owning a CFD is very similar to owning a share. Its like owning the share without actually owning the share. You get most of the benefits such as capital gains and dividends besides a few such as voting rights. CFDs however give you access to a long list of options that shares do not such as the ability to go short, trade on margin, to sell on a down-tick, low commissions, no stamp duty or GST plus other tax exemptions and the ability to trade all types of securities.
But, to be clear, with CFDs you never actually own any shares. If it matters to you that you cannot vote at the annual general meeting of the company, then you should continue to be a share investor. However there are major financial advantages to using CFDs on equities, as they are a derivative product and allow significant gearing or leverage of your investment.
When trading with CFDs you enjoy the benefits of share price speculation at a fraction of the cost of buying the shares, so if your trading account is limited contracts for difference have a marked advantage. CFDs are available on a wide range of financial products, including indices and foreign shares, so although not all domestic shares are offered you can enjoy a large range of possible markets, and you can take out short (bearish) positions as easily as long.
Compare that to shares. In the United Kingdom, for instance, taking a short position in physical shares can be somewhat complicated and expensive. It may imply rolling your position every 20 days. Each time you do this, your pay a brokerage commission and 0.5% stamp study. The possibility of leverage is also limited. By contrast, placing a short CFD is esay and can be held indefinitely. You open a trading position by 'selling' a CFd in the share or instrument you are expecting to fall and later close your position by buying it back, hopefully at a lower price.
One argument you will find against using CFDs is the financing charge. As usually happens when you pay only a small part of the cost, you will be charged interest on the amount that you are effectively borrowing. This is the same as trading in the futures markets, for example. The interest charge is not huge, usually a couple of points above a published lending rate, so if you are a short term trader holding on to positions for at most a few weeks at a time, your gains will easily cover the interest and leave you a profit.
Another difference from share holding is that when you use CFDs the price is 'marked to market' each day, and your account is credited or debited by the change in value and the interest charge. What this means is that you can get a margin call if your account goes down, and you will have to find more money to send to your broker. For this reason, many experts suggest that you only use about half of your funds with CFDs and keep the rest in reserve against any such need.
Although you should be cautious in doing so, having the CFDs marked to market can mean that you receive further capital into your trading account without closing your position, and can do further trading while still holding on to a successful trade. That is not possible in any way if you have invested in shares. On balance, for flexibility and for making your money more effective, contracts for difference score in many ways over traditional share investing, and should be a part of any trader's portfolio.