CFD trading is an alternative to trading shares using a traditional brokerage setup. In this article, we’ll be comparing and contrasting these types of trading.
In our introduction to CFDs, we explained that a CFD is a derivative; an agreement between trader and CFD provider to exchange a profit or loss at the close of a position, based upon the price movement of underlying security while the position was held open.
Underlying asset
The similarities of CFD and stock trading will be apparent to anyone who has used both types of trading platforms online. The series of steps you would follow to take a long position is almost identical:
- Search for a stock by name or ticker symbol and click ‘buy’
- Enter the value of position you wish to take
- If you are trading during trading hours, you’ll receive a live quote from your broker
- Click to confirm the trade
- The position is now open and can be viewed in your open trades screen together with a live profit/loss.
The experience feels very similar but what is happening behind the scenes is very different.
If you are trading through a traditional stockbroker, the broker will execute your trade directly on the London Stock Exchange or through a member broker intermediary who will do the same. The trade would involve buying an asset from a seller - via their own broker. A clearing house is used by the brokers to administer the settlement process which sees the share ownership and cash transferred between the parties.
When you buy a long CFD, your trade will be executed internally within the CFD provider's trading platform in an instant, and that’s it.
The CFD provider may in turn choose to make trades to hedge its net exposure, but this is a separate risk management process and isn’t directly linked to each CFD.
Long versus short
Share trading allows investors to either own stock or not. If you own a share, you are said to be ‘long’ on the share and you will naturally profit if the price of the asset rises during your period of ownership.
CFD trading offers long positions, but it also allows traders to take a ‘short’ position on a stock. This means that a trader will profit if its price falls.
To replicate a short position with real shares, you need to take the complicated step of firstly borrowing a quantity of stock, and then selling that stock on the open market. As you will need to buy back the stock eventually to return the borrowed shares to the lender, you will profit if the price falls and you can buy them back for a lower price than you originally sold them for. The most well-known traditional UK stockbrokers do not allow retail investors to borrow stock and therefore shorting is not possible with a standard share dealing account.
The ease of taking out short positions is one of the core reasons for CFDs to exist - it has been a key feature of CFDs since their inception in the 1990s. Because a CFD is simply a contract, where parties agree to exchange money on the outcome of a price direction, it’s as simple to write the contract as a short position as it is to write it as a long position.
Settlement period length
As mentioned above, trading real shares involves transferring the legal rights to an asset between third parties who may not trust each other. To solve this problem, intermediaries known as clearing houses were established to act as trustworthy entities to ensure that cash and shares change hands in an orderly fashion.
As this process involves multiple parties, and rigorous checks & balances, it takes a few days to complete. The standard settlement period for UK retail investor share trades is T+2 which means two days after the execution of the trade.
This means that retail investors may have to wait up to three working days after they have sold their shares before they can access the cash to redeploy.
CFD trading occurs at a much faster pace because all trading occurs on the same internal system. This means that trades can exit and enter positions without any meaningful delay.
Taxes
The purchase of shares triggers a Stamp Duty tax which is levied at 0.5% of the value of the transaction and is collected and paid over by your broker.
CFDs are subject to different rules because they don’t involve the purchase of an underlying asset. This means that taking a long position in a company via CFD does not trigger Stamp Duty. This creates a 0.5% saving on the value of the trade.
Profits arising from the sale of shares or settlement of a CFD are subject to the Capital Gains Tax regime, and any dividend income is subject to income tax. For more information, read our guide on how investments are taxed.
Voting rights
Real shareholders are entitled to any voting rights assigned to the shares as defined in the company articles of association.
This includes the right to attend an AGM or special shareholders meeting, and vote upon any proposals submitted by the board or shareholder group.
The vast majority of British investors do not exercise their rights as shareholders, because most brokers hold their shares in ‘nominee accounts’, which means that the broker, rather than the individual, is named on the share certificate. This makes establishing the owner of shares more complex than when shares are registered in an individual's own name. Some brokers, to their credit, have deployed systems to enable shareholders to attend AGMs and make votes, but most do not take advantage of this.
CFDs afford no voting rights to an investor because the investor does not actually own shares in a company.
Fees
Traditional stockbrokers will charge:
- General account fee (fixed or % of assets) to cover administration costs of operating the account
- Share dealing fees (usually fixed) for transacting a trade
- FX fees (applied when shares are bought or sold in a foreign currency)
CFD brokers will charge:
- A bid/offer spread - being the premium added to the live market price at purchase, and deducted from the live market price at sale, which effectively amounts to a transaction fee. The lower the spread - being the difference between buy and sell price - the less you are being charged to trade.
- Overnight fees - where CFD positions are held overnight you may be charged an overnight fee, being 1/365th of an annual charge, which is usually an interest rate. This charge will vary depending on the exact position you are opening therefore always read the T&Cs carefully before you open a long-term position.
- Foreign exchange fees - similar to a stockbroker, CFD firms may apply a fee or use below-market rates when converting your domestic currency into transaction currency.
For more detail about the fees charged by CFD providers, look no further than our dedicated article on this topic: Understanding the Fees of Trading CFDs.
Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The vast majority of retail client accounts lose money when spread betting and/or trading CFDs. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.
Tax disclaimer
Tax treatment depends on individual circumstances and can change or may differ in a jurisdiction other than the UK.
