Stocks CFDs: Overview, How it works and How to trade

If you consider yourself an experienced investor, a savvy predictor of trends, or a shareholder looking to branch out from owning stocks, you may enjoy an increasingly popular trading option, stock Contracts for Difference (CFDs) or CFD stocks^[1].

CFDs provide a unique opportunity to trade by predicting price movements in the market, without holding the underlying assets.

As stock CFDs may be advantageous both as a type of CFD and in comparison to stocks themselves, you may be curious about what stock CFD trading is, how stock CFDs differ from regular stocks, the costs, and how you can trade stock CFDs.

How Do Stock CFDs Work?

A CFD is a financial contract between an investor and broker that allows the exchange of difference between the market value of an underlying asset when a contract opens and the value when it closes. Accordingly, the underlying asset in the case of a stock CFD is a stock. While you do not purchase or hold any stocks, you will be able to trade the fluctuation of the market value of the stock in question.

Stock CFDs offer traders the opportunity to access and forecast stock movements for a large range of companies all over the world, on international stock exchanges. When you open a position on stock CFDs, you have the chance to predict how the stock will perform on the stock market.

If the stock market reflects your prediction, whether a positive forecast or a negative forecast, you can profit from the fluctuation. However, if the stock market does not follow your prediction, you will incur a loss.

How Do Stock CFDs and Stocks Differ?

The major difference between a stock and a CFD stock is that the stock CFD is a derivative of the underlying security; in this case, the stock itself.

A stock is a financial instrument representing a share of ownership in a company. Stocks make movements on the stock market depending on the company and industry they represent; the most popular stock exchanges include the Dow Jones Industrial, NASDAQ, and Dax.

Correspondingly, shareholders can profit or lose from these movements, as stocks either gain or lose value over time. There are two ways to profit when purchasing stocks – when they rise higher than the price they were bought at, or when you receive sufficient dividends to cover your cost.

Conversely, you can use stock CFDs to speculate on the fluctuation in the price of a stock, without owning any stocks directly. However, you will sacrifice some of the entitlements that come along with owning stocks, such as the right to company information and the right to vote.

Here are some of the other differences between stocks and CFD stocks.

Leverage

Naturally, since this can be a high risk and high reward type of scenario, there are fees associated with this type of trading. The margin rate is typically a percentage (1% to 50%) of the total position value.

There may be associated fees, it still allows you to trade underlying stocks whereas you may not have had capital to purchase the same number of shares in a company.

Stock CFDs may be more accessible for larger, popular corporations than owning and trading the underlying stocks because stock CFDs are traded using margin. This way, even if you don’t have the finances to fund a large position, you can still do so by trading stock CFDs on margin.

Short Selling

Another significant difference is how easily you can engage in short selling with stock CFDs. With stocks, short selling involves maneuvering several rules and regulations. With stock CFDs, there is much less restriction (apart from a few types of stocks that cannot be short sold).

The process is actually quite simple on CFD platforms; for instance, you simply need to determine whether you wish to open a short (positive prediction) or long (negative prediction) position.

Global Access

Finally, CFD stocks offer a significant advantage over stocks due to the fact that you can access market options from all over the world, rather than being limited to one or a few countries. Likewise, if you own stocks from other countries, it can be expensive to ensure the safety and security of those securities.

Accessing and opening positions on stock CFDs around the world in a secure manner is easy and affordable.

What Are the Costs of Trading Stock CFDs?

There are a few costs associated to trading all CFDs, although there could be extra fees associated with trading stock CFDs. In most CFD trading, you will need to pay account-related charges, holding fees, transaction costs, margin rates, and spreads. In stock CFD trading, you will also need to pay a commission and any applicable taxes.

• Account Charges: Depending on where you open an account, you may pay a one-time activation fee or an ongoing inactivity fee.
• Holding Fees: When you open a CFD, sometimes you will keep your position open for a long period of time as you may predict a mid-term trend for your trade. The majority of brokers will charge a holding fee, or overnight fee, for holding your agreement daily. This may be a positive or negative amount.
• Transaction Costs: Some brokers will charge a percentage for deposits or withdrawals.
• Margin Rates: If you open a position with leverage, you will need to pay a percentage (1% to 50%) of the total position value.
• Spreads: When an investor opens a CFD position, the CFD will have a bid price (for predicting a downward trend in the market) and an offer price (for predicting an upward trend in the market). The spread is the difference between the two amounts.
• Commissions: When you open positions in stock or share CFDs, brokers will charge commission fees on your stake.
• Taxes: You may need to pay Capital Gain Tax if you have made a profit above a certain amount or Corporation Tax if you are trading stock CFDs as a company entity ^[2].

How to Trade Stock CFDs?

Now that you have a better understanding of how CFD stocks work, you still need to learn how to trade them. There are three main components to trading CFDs, yet there are steps involved that pertain specifically to stock CFDs: opening a position, monitoring a position, and closing the position.

Opening A Position

When you open a position, you speculate on the price movement a stock will make in a certain amount of time. When you forecast an upward or positive trend in the market, you are ‘going long’ (buying), and when you predict a downward trend, you are ‘going short’ (selling). 

These speculations may come from your knowledge of the particular company or the stock market, and could also be from beliefs about the economy in general. For instance, many investors place long term positions because they have an optimistic outlook on the immediate future of the economy^[3].

Another important factor in this stage of investing is your trade size. If you are opening a position on stocks, making a prediction on 200 shares might be termed a position with 200 contracts. The quantity of stock CFDs will increase your profit, with every movement point in your favour.

However, it will also increase your loss for every movement point against your favour. In this instance, it would be 200 times the difference incurred.

Monitoring A Position

As the investor, you are in complete control of the lifespan of your position. As the stock exchange can be particularly volatile, it is important to monitor your profit or loss on a regular basis. This way, you will know when to add new trades or close an existing position.

Although you can close your position whenever you deem fit, you can also opt to place a guaranteed stop or stop loss on your position; this ensures that you limit your losses beyond a certain threshold.

Closing A Position

When you close your position, your deal size and leveraged position will be taken into account when calculating your final profit or loss. This is also when the spread and other potential fees come into the equation.

Moving Forward with Stock CFDs

Now that you have a sufficient understanding of stock CFDs, you can apply your grasp of market trends and stock movements towards this valuable trading opportunity. You have the option to use the different brokers available, being careful to choose a company and industry which you understand to a significant extent. Secondly, you can utilise your knowledge of stock CFD features and costs to your advantage while opening positions.

It is always beneficial to keep in mind that stock CFD trading is a high-risk trading opportunity, as it has the potential for both profit and loss. This is especially so because stock CFDs are leveraged products. It is important to trade responsibly and develop risk management strategies to curtail potential losses.

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