What is the difference between Equities and Equity CFDs?
These instruments might look the same at first glance but are very different in nature and makeup; let's take a closer look at the difference between Equities and Equity CFDs.
With Contracts for Difference (CFDs), investors can profit from price movements of the underlying asset, and this underlying asset can be an equity or share in a company. Since shares or share indices often serve as an underlying and reference value for CFDs, the question arises, what is the difference between trading in shares and trading in CFDs?
Let’s look at a simple example; if you buy a share at a price of R100 and sell it for R110, you will profit 10 Rand. The investor can only make a profit if the share price goes up. With an equity CFD, investors benefit from share gains when buying, and by selling, the CFD, also known as going short, capitalises from declining share prices.
Scenarios on rising or falling prices with CFDs
However, a CFD is a leveraged product instead of a share bought on a 1:1 basis. Thus, investors can profit enormously from long CFDs rising and short CFDs from falling underlying prices. If the market expectation is correct, leveraged profits can be achieved. On the other hand, leveraged losses occur if the underlying asset moves in the "wrong direction". The leverage is possible because investors only deposit a small part of the underlying as security (margin). The smaller the margin, the greater the leverage.
Calculate leverage and run through scenarios
The direct leverage is calculated by dividing the position size by the margin. An example: A share costs R100. For the CFD on the same stock, however, the investor only has to deposit R10 as a margin, i.e., 10 percent of the stock’s value. Thus, the leverage is 10. The calculation: 100:10 = 10. Suppose the investor buys a long CFD on the stock that increases by 1 percent to R101. While the stock investor achieves an increase in value of 1 percent, the CFD investor can be pleased to book a profit of 10 percent. This is because his CFD has increased by 1 Rand, just like the share. One Rand profit on a stake of R10 gives a 10 percent profit.
But what happens if the CFD strategy does not work out in the example? Let’s assume that the share price falls by 1 percent to R99. Then the long CFD loses 1 Rand. In relation to the capital investment of R10, this would be a loss of 10 percent. On the other hand, the stock investor would have lost only 1 percent.
The Broker as Counterparty
Another critical difference between the two forms of investment: CFDs are not traded on the stock exchange, unlike shares. Investors trade CFDs directly via a provider - more precisely, via a broker who offers CFD trading. Therefore, contracts for difference are legal agreements between investors and brokers. The broker sets the prices, determines the conditions, and offers corresponding trading opportunities via its platform. Against this background, it is crucial to choose a reliable broker. And: Before investors trade CFDs, they must open a securities account with their broker.
Limit losses with order supplements
One advantage of CFDs is their low costs. Thus, there are usually no or only low order fees. As with stock trading, investors can protect themselves from more considerable losses with order supplements. For example, with the addition of "stop-loss," investors set a price limit above which the CFDs are automatically sold at the next tradable price. A variant of this trading instrument is the "dynamic stop-loss." An example: An investor buys a long CFD on a share quoted at R100 via the online trading platform and first sets the stop-loss mark at R90. If the share price touches this mark, the CFD position is closed out at the market price.
Another scenario: While trading, the underlying share rises to R110. Now the investor pulls the stop-loss limit up to R100. This way, he can further minimise possible losses and no longer suffer losses from a particular mark. Dynamic stop-loss orders are possible manually or automatically, as described in the example.
CFD trading made easy:
- With CFDs, investors can also bet on falling markets. The margin creates leverage.
- CFDs offer higher potential returns and are riskier than stocks.
- Investors choose the broker of their confidence.
- Investors can keep losses in check with stop-loss order.