CFD Trading or Traditional Trading Which One is Right for You

While traditional forms of trading have gained popularity the world over, a lesser-known trading instrument - Contracts for Difference, or CFDs - is rapidly gaining traction. CFD trading and traditional trading both have their own unique characteristics, advantages, and disadvantages, with some key differences that set them apart.

The good news is that traders can use both to boost their portfolio returns. In this article, we delve into the pros and cons of CFD trading and traditional trading to help you understand how they can help you grow your portfolio.

Quick facts:

• Contracts for Difference are derivative instrument where traders can place bets on the price movements of assets without owning the assets themselves.
• They are different from the traditional form of trading, where traders fully own and hold the assets.
• Traders who trade CFDs can also access leveraged trading to trade a higher volume with a smaller pool of capital.
• Both offer access to a range of assets, including forex, gold and other commodities, stocks and more.

Table of Contents:

• What is CFD Trading?
• Pros of CFD Trading
• Cons of CFD trading
• What is Traditional Trading?
• Pros of Traditional Trading
• Cons of Traditional Trading
• Trading FAQs

What is CFD Trading?

Contracts for Difference (CFD) trading is a derivative trading method that allows investors to speculate on the price movements of underlying assets without actually owning them. They mirror the price movements of the underlying asset, and traders make bets on these moving prices rather than buying or selling the assets themselves.

How does CFD trading work?

Here, the buying party and selling party enter a “contract” where the buyer agrees to settle any “difference” in price from the current value of the asset and its value at the time of settlement. Hence the name “Contracts for Difference”.

A key feature of CFD trading is leverage. Leverage allows you to trade a higher volume with a smaller deposit.

Here, based on your deposit (or margin), your broker will “loan” your additional capital based on the leverage ratio applicable to you so that you can trade a higher value. We use the word “loan” carefully as you don’t keep the capital - you just trade with it.

Hence, there is no question of returning the funds to your broker (since you can’t keep it in the first place), but your profits or losses will be based on the full value of your trade.

Another unique feature of this form of trading is the ability to go both, or long or short.

This means that traders can benefit from prices not only when they rise but also when they fall. The option to go both long or short gives traders the flexibility to hedge by taking contrary positions, thus minimising their net risk.

Pros of CFD Trading:

• Leverage: CFD trading offers significant leverage, allowing traders to control a larger position with a smaller initial investment. This can magnify both gains and losses, so traders need to have a robust risk management policy in place.
• Range of assets: CFDs provide access to a wide range of financial instruments, including stocks, commodities, cryptocurrencies, and indices. Forex, gold and oil are some of the most traded CFD assets due to their constantly changing prices.
• Ownership: CFD traders don't need to own the underlying assets, allowing them to avoid the costs and complexities associated with traditional ownership. Brokers will typically complete initial identity verification, after which traders can go straight to trading.
• Short-selling: CFD trading enables traders to profit from falling markets by short-selling, which can be challenging or impossible in traditional trading. This means that you can take advantage of prices not only when they rise but also when they fall.
• Hedging: CFDs allow you to hedge your positions, meaning that you can open a new trading position to offset any potential losses you think you may incur from existing positions.

Cons of CFD trading:

• Risk: While leverage can amplify potential profits, it also exposes traders to higher risks. Traders will typically have a risk management plan in place to mitigate losses.
• Short-term: CFDs are suited for traders looking to make short-term earnings rather than hold assets for longer periods, such as a certain number of years.
• Ownership: Traders who want to outrightly own the underlying asset can opt for traditional trading, as CFD trading does not offer actual ownership of the asset being traded.

What is Traditional Trading?

CFD trading is very closely related to traditional trading. Traditionally, trading involves buying and selling different securities, such as forex pairs, stocks, gold, etc., with full ownership. Unlike CFDs, however, when traders buy and sell traditionally, they become direct owners of the assets and bear the full risk associated with ownership.

Moreover, leverage is not available in the traditional mode of trading. This means that you will need the full upfront value of the trade to execute it, requiring you to make substantial deposits of your own money.

Pros of Traditional Trading:

• Ownership: Traditional traders have full ownership rights of the assets they purchase, providing them with potential dividends, bonuses and other rights.
• Range of assets: Like CFDs, traditional trading also gives you exposure to a vast range of asset classes across diverse instrument classes.
• Access to exchange: Some traders, especially highly experienced or institutional ones, may prefer to deal directly with the exchange when trading, which is why they may prefer traditional trading.
• No expiry dates: Traditional trading does not involve contracts with specific expiration dates like in derivative instruments. This allows you to hold your assets indefinitely, giving you more flexibility in your decisions.

Cons of Traditional Trading:

• Capital intensive: Traditional trading often requires a more significant initial investment, limiting accessibility for some traders that may not be able to shore up the entire value of their trade upfront.
• Slower trading: Traditional trading involves physical delivery, settlement, and ownership transfer, which can result in slower execution compared to the speed of execution that CFD traders enjoy.

The choice between CFD trading and traditional trading depends on your risk tolerance, financial goals, trading strategy and familiarity with the specific trading instruments.

At the end of the day, CFD trading and traditional trading both meet somewhat similar trading needs but with crucial differences that have a direct impact on your trading activity.

CFD trading offers the convenience of leveraged positions, easy market access, and the ability to hedge your potential risks. On the other hand, traditional trading provides direct ownership of assets and flexibility in when you want to close your position.

At the end of the day, your portfolio can benefit from both traditional trading as well as CFD products – taking the time to understand how you can incorporate both into your portfolio can help you maximise their value.

Trading FAQs

Q: What is trading?
A: Trading refers to the buying and selling of financial assets, such as stocks, currencies, or commodities, with the aim of making a profit based on price fluctuations. Here, the trader takes actual ownership of the asset they are trading.

Q: What are CFDs?

A: CFDs, or Contracts for Difference, are financial derivatives that allow traders to speculate on the price movements of various assets without owning the underlying asset. The trader gains or loses based on the difference between the asset's price at the contract's start and end.

Q: How do CFDs differ from traditional trading?

A: Unlike traditional trading, where traders buy and own the actual underlying asset, CFD trading involves speculating on price movements without owning the asset. CFDs provide flexibility to profit from both rising and falling markets through long (buy) and short (sell) positions, and they often offer leverage to amplify potential gains and losses.

Q: What is leverage?

A: Leverage in trading refers to borrowing funds from a broker to trade a larger position with a smaller initial investment. It magnifies potential profits or losses, as gains or losses are based on the total position size rather than the initial capital invested.