It is hard to convincingly call any part of trading stocks “simple”. Even the concept of stocks in general is extremely abstract. Many people get hung up on questions like, “What do you actually own when you buy a stock?” or “How is ownership of a stock transferred through a digital medium like a trading app?”
Answering these questions is critical to understanding where the value of stocks comes from. But there is another layer to it that even experienced traders overlook: If you do not understand how a stock works, then there is no way to understand how different kinds of securities innovate on stock trading.
That is what we are going to talk about today, using one of the most popular securities to be derived from stocks: Contracts for differences, also known as CFDs. What makes CFDs so popular is their profit potential—which of course comes paired with a degree of risk and volatility.
We will begin by talking about what each security is, meaning where it gets its value and how it works.
Table of Contents:
What are Stocks? 🤔️
Stocks, sometimes called shares, are percentages of ownership of a company. They are never a whole percentage, but a fraction of a percentage, usually in the area of .00001%. Two things can happen when you buy a stock. Either you are buying it from another person, or from the company themselves.
When you buy a stock from a company, they issue a “stock certificate”. This indicates the fact that you own the stock, how many shares of the company you own, as well as the price at which you bought it.
When you buy a stock from another person, you are technically buying their stock certificate. Their name on the certificate is replaced with yours (though the fact that their name was on the stock at one point is still kept in record). Of course, you can buy less than they bought, which would mean the creation of another stock certificate. But the idea is the same: You can buy stocks from someone else.
You can make money off of stocks through two methods: You can either sell the stock, which can be done with any stock. Or, with certain stocks (but not all of them) you can make money passively just by holding them. This is called “dividends” and it represents a return for giving the company your money.
What are CFDs? 🔎️
Contracts for differences are securities that are based off of stocks but are quite different in many important ways. The biggest difference is the fact that you do not actually own a stock when you buy a CFD. This surprises many people. There is no stock certificate, no fractional ownership of the company.
When you buy a CFD you are buying into a contract, and it is critical that you read that contract so that you understand what you are spending your money on.
It is a rather complex process, so let’s take it step by step.
Step One: Establishing the Terms
The first thing you will do when you buy a CFD is establish the terms with the seller from whom you are buying the CFD. You might think this is obvious, but some people who sell CFDs will be selling them wholesale. That is your warning sign that they are scamming you. Never buy a CFD without negotiating.
The first thing to establish in these terms is a stock. Then, you pick a date, and then a price. What you are saying by purchasing a CFD is that the stock will be higher or lower than the selected price on the selected day. The seller of the CFD will take a different position. So, if you said it would be higher than the selected price, then they will usually say it will be lower than the selected price.
Step Two: Paying the CFD
Once you actually arrive at the date set by the CFD, you will compare the current price of the stock to the price you indicated in step one. If you claim that it will be a higher price and it is a higher price, then the seller will pay you the difference between the selected price and the actual price.
If you claim it will be a higher price and it is not a higher price, then you pay the seller the difference.
Step Three: Selling the CFD
A contract for differences is a contract similar to a stock certificate. And like a stock certificate, you can replace your name with someone else’s name on it by selling the contract to them.
It should be noted that this is an optional step to handling the CFD. But you might also have picked up on some of the risks associated with buying CFDs in step two. Sometimes, if it looks like a CFD might end up costing you money rather than making you money, selling a CFD is a good call.
What are the Differences Between Stocks and CFDs? ➡️
While you might have picked up on the differences between the two securities just from having them described to you, we are going to underline the differences anyways just to be clear.
- Owning a stock means owning a piece of a company
- You can own a stock for as long as you want
- You make money off of stocks from either selling it or dividends
- Low risk, low reward
- Owning a CFD means owning a contract related to a stock
- You only own the CFD until the selected date
- You can make and lose money through CFDs
- High risk, high reward
Why Choose One Over the Other? 👀️
Stocks and CFDs involve drastically different skills. If you can day trade instantly and in large amounts, then trading stocks is not about “timing the market”. You don’t need to know when a stock is at its highest or when it is at its lowest. You can just buy shares, let them increase by a penny, then sell.
There are methods of trading stocks that involve timing the market. That means buying when you expect the price to be at its lowest and selling when you think it is at its highest. That is still valid, but it is difficult and slightly higher risk. The important thing is that stocks give you options.
The skill involved with CFDs is timing the market to the Nth degree. You are not just trying to figure out what price something will be at by the end of the day. You are trying to figure out what price it might be at a few days, weeks, or months from then. But more than that, you are also negotiating with the other person involved with the contract. Name a price too outrageous and they won’t take it.
Which is Better, Stocks or CFDs? ➡️
Both securities have their niche. Stocks are better for their versatility. You can play it fast and loose with stocks. You can also use them entirely for their passive income utility. But stocks are never going to be a lottery ticket, and they will punish you if you try to use them that way.
CFDs will also punish you. But at the same time, they are much more viable if you are looking for a lottery ticket. You see, you do not just have to buy one CFD from one person. You can buy a bulk of the same CFDs from an investment firm. They will be glad to risk their money against yours.
And if the CFD comes out wrong and you end up owing them tons of money, then they are glad to receive monthly payments from you as you slowly cover the massive cost of all those CFDs.
In short, CFDs are extremely risky.
Comparing the Risks of Stocks and CFDs ⛔️
Imagine you buy a stock for £100. The next day, the company that issued the stock goes out of business. If that happens, then you lose your £100. The stock is worthless since it no longer owns anything.
In that situation there is a maximum to what you can lose. Stocks are limited in their losses by their value. But CFDs are different. Imagine that you enter into a contract for differences that says a stock will be below £100 on a certain date. If it is £25, then you get paid that £75 of difference from the seller.
But what if it goes up to £125? Then you pay them £25 instead. What if it goes up to £400? Or £10,000? The thing about CFDs is that their loss potential is technically infinite. It is basically impossible for a stock to go from £100 to £10,000. But what if you buy 1000 of the same contracts?
Then even a small loss potential becomes enormous.
Stocks and CFDs are different securities for different kinds of traders. One cannot replace the other, as both require such different skills to even understand how they are valuable.
But be sure you know the difference between them.