CFDs vs. Stocks: Which One is Better?

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

1. 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.

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