To trade CFDs or to invest? It’s a question many novices ask when they first enter the financial world. The answer is that both products have their benefits – it’s a matter of choosing the one that suits you.
Contracts for Difference (CFDs) are a flexible way of speculating on the value of a financial instrument. These investments allow you to trade on the price movements of different assets, without actually owning them. CFDs are helpful for traders who wish to trade based on market trends, but may not have sufficient capital to trade larger volumes.
The following guide will go into more detail about both options, and help you decide which side of the CFDs vs investments debate you fall on.
This article at a glance:
- Unlike investing in a physical asset, where investors only benefit when its value increases, CFD trading involves profiting from upswings and downswings in price.
- Key differences between CFDs and investing in physical assets include ownership benefits and leverage.
- CFDs and investments can both be part of your financial plan.
What is CFD trading?
CFD trading is the process of speculating on price movements. This means you take a position against the value of a financial instrument, rather than buying the underlying asset. In this case, instead of actually buying or selling, say, gold or forex, you would play the market based on your estimations of whether the price of the asset would go up or down.
This indirect connection to the asset means you can profit when its value changes. But, unlike actual owners of the asset who benefit only when its value increases, you have the opportunity to profit from upswings and downswings in the price.
You can do this by taking out one of the following contracts:
You can have a contract where you “go short” and take a “sell” position. This means you’ve taken an interest in the asset but feel like it’s going to lose value.
You can have a contract where you “go long” and take a “buy” position. This is where you have an interest in the asset and believe its value will increase.
What you make from your trade is the difference between the price of the asset when you took the position, and the price of the asset when your position closes.
What is investing?
Investing is when you actually purchase an asset. Unlike CFDs, you only benefit from the upside when you invest. Therefore, you have to be confident that its value will increase over time, because you own the asset in full or part.
Let’s say, for instance, that you have a friend who is looking to sell their apartment. You’re interested in buying the apartment, but can’t afford to pay it’s full value. Subsequently, you ask your parents and partner to pitch in. Your parents each pay about 20% of the apartment’s value, your partner chips in another 25%, and you cover the remaining 35%.
Between everyone in the group, you’d now own 100% of the apartment. Each of you have a say in what happens to it, relative to your share of investment in the apartment. When the market value of the apartment rises, so does the value of your share in the apartment. Should you choose to sell your stake, it would result in a profit.
The converse is also true, i.e., when the apartment’s market price falls, so does the value of your stake in it.
A key difference between CFDs and investing lies in the amount of control you have over the asset. CFDs are an indirect way of having an interest in an asset, unlike investments, which you directly own. As you’re watching from the outside, you don’t have any control.
CFDs vs. investing: Features and differences
So far, we’ve understood the fundamentals of CFDs and investing. We know that one allows you to speculate on price movements, and the other allows you to purchase the underlying asset (or a part of it).
With that in mind, here are some features and differences to consider in the CFD vs. investments debate:
- You are speculating on the value of the asset.
- You can take a leveraged position. This means you can invest a small amount but still have exposure to the full value of the asset.
- For example, let’s say the value of an asset is 500 USD. Instead of committing 500 USD, you could risk 50 USD with 10X leverage to gain full exposure (50 X 10 = 500).
- Leverage can give you huge profit-making opportunities. However, it can also amplify your losses. It’s important to put appropriate risk management measures in place to mitigate these risks.
- CFDs allow you to hedge your position based on how you think prices will shift. This means that you can bet against the market as well, unlike actual investments where you only profit if the value of your asset goes up.
- You can trade CFDs on a variety of financial instruments, including stocks, forex, indices, futures, and commodities.
- There is no leverage when you’re directly investing in assets. The price you see is the price you pay.
- Your risks and costs are directly proportionate to your exposure, i.e., your maximum risk is limited to the value of your investment.
- Investing in certain situations gives you additional benefits. For example, if you buy shares in a company, you may receive dividends (annual payments taken from the company’s profit), or get to vote on matters that affect the value of the company.
- You can invest in stocks and exchange traded funds (ETFs). You can also invest in other assets such as cryptocurrencies.
CFD trading vs. investing: An example
Let’s consider two scenarios for the same asset.
Company A sells computers. The value of a single share in the company is 10 USD. Given that computers are popular, you assume the company’s value will increase over time.
Using the above example, you have two choices: use a CFD or invest. In case of the latter, you’d use an investment platform of choice to directly buy shares from Company A at the listed share price. If you decide to buy, say, 30 shares in the company at a price of 10 USD, your total investment in the company would stand at 300 USD.
Trading CFDs in Company A at a profit
In a separate scenario, you don’t want to commit the full value of a share, so you decide to trade CFDs on Company A with a CFD brokerage that offers you 5X leverage. Expecting its value to increase, you take a long position.
This lets you purchase one CFD for a fifth of the share price, i.e., a margin of 2 USD. In this example, you go ahead and purchase 20 share CFDs.
Margin: 2 USD
Number of share CFDs purchased: 20
Total investment: 40 USD
After a week, the share price increases to 13 USD. You sell your share of CFDs and make a profit. Since the price per share went up by 3 USD, and you had purchased 20 share CFDs, you made a profit of 60 USD minus the commission charged by your broker.
Price change: +3 USD
Gross Profit: 3 USD x 20 shares = 60 USD
Trading CFDs in Company A at a loss
In our earlier example, you walked home a happy investor having made a profit on your initial investment of 2 USD. Now imagine that the price fell by 1 USD, instead of going up by 3 USD. The price of the share now stands at 9 USD. Since the price has declined, and you took a long position, you have now made a loss on your trade.
In this case, your loss will amount to the price difference for 20 shares, as well as the commission you will pay your broker.
Price change: -1 USD
Gross Loss: 1 USD x 20 shares = 20 USD
Ultimately, your decision to trade CFDs or invest directly in assets depends on what you seek to achieve with your money, how many years of experience you have in financial markets, how much risk you’re willing to take, and what your trading or investing strategies are.
Of course, CFDs and investments can both be part of your overall financial plan, but understanding their differences, including the potential outcomes, is the key to figuring out how you want to use them to achieve your financial goals.
CFDs vs. investments FAQs
Are CFDs profitable?
Yes, they can be. However, like any financial product, they come with risk, and no profits are guaranteed.
Is it better to invest or trade CFDs?
This depends on your financial goals and strategies. If you prefer to think about long-term gains and believe an asset will increase in value, you should invest. If you prefer to make short-term plays with the flexibility of profiting when an asset increases or decreases in value, you should trade CFDs.
Are CFDs safe?
All of our CFD options are safe and overseen by financial regulators. However, CFDs are leveraged products that come with risks.
Are CFDs legal?
Every CFD we offer is 100% legal. As long as you use a licensed broker and a secure platform, everything is legal, safe, and secure.
This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. INFINOX is not authorized to provide investment advice. No opinion given in the material constitutes a recommendation by INFINOX or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.