How does Share CFD trading work?

Trading shares has always been present and many profited from it. Buying and selling shares on a stock exchange, however is a bit time consuming as well as it is not so cost effective, i.e. you have to hire a broker and execute a deal if there is counterparty. Also you have to obey certain rules such as minimum trading volumes. Having this in mind, is there an easier way to enter the markets? The good news is that there is and it is called Contract for differences on shares.

After you read this article, please leave me a comment! Tell me if it contributed for your knowledge, and if so, how will you use it in your trading strategy?

A Contract for difference is a financial instrument, which constitutes a contract between two parties, a buyer and a seller that each of them will pay the difference is the price of an asset between the moments the deal is made and when it’s closed. With this type of trading there is no physical exchange of an asset but just n agreement based on the price of that asset. So shares can be also traded via CFDs and that is how they become widely accessible to the retail audience. The share CFD trading conditions are quite cost effective and that is one of the main reasons why these instruments are so popular.

How do CFDs differ from traditional share trading?

One of the main differences is that CFDs are traded with leverage. This mean that you are able to buy significantly more shares that you are able to purchase with the money available in your account. The usual leverage for CFDs on shares is 10:1 meaning you need 10% of the cost in order to purchase the shares. As your exposure is leveraged this can lead to high profit but also losses. If you are familiar with Forex trading, you know very well how this works. With share CFDs it is just the same with the difference that it is only 10:1.

Another main difference and certainly an advantage is that CFDs on shares can be traded short. Meaning, you can sell shares without owning them at the first place. At a glance it looks strange to do that, especially for beginner traders. When they ask me how it is done, I try to explain it in a straightforward manner: imagine that nobody buys or sells anything, it is just you both bet on the price direction. In fact, this is how it works. Two counterparties with different visions about the future bet against each other and the party that lost the bet pays the difference to the other party. In this sense, if you believe that the share price of IBM will fall with 2% in the next month, you place a short order, i.e. sell CFDs on IBM shares and wait one month. If you guessed right, you should be able to take your 2% as a profit after closing the deal, i.e. buying the shares at a cheaper price and getting the difference.

Last but not the least, the major difference between CFD Shares trading and conventional share trading is the nature of the counterparties. I will try to describe it by giving an example:

1. At the stock exchange – When you are at the stock exchange, meaning you have a broker to represent you, buying shares will most probably happen this way: You call your broker on the phone and placing an order: “Hey Jim, I would like to buy 5000 Apple shares today, please give me a quote”. Jim on his side, will look for the available sell offers and will find that currently there is an offer for 4000 shares at a price of $300 per share and 1000 more priced at $305 per share. In this case he will make the average and will inform you. You will purchase those shares and will pay commission to your broker for the service. After the deal is made, you currently own 5000 shares of stock of Apple and are free to sell them later. It is important to note that if there wasn’t anybody selling at the moment you weren’t be able to purchase the shares.  The same is true at a later stage – if nobody wants to buy Apple shares in the future, you will have to keep them and be long on Apple shares.
2. Trading CFDs shares – When you trade CFD shares you usually place an order to your CFD broker, either via phone or electronic trading platform. In this case the CFD Broker (sometimes I wonder why it is called “a broker”) immediately executes your order and acts as a dealer. In fact, the CFD broker does not look at the stock exchange but rather deals you the CFDs on shares and takes the counterparty risk. It is important to understand that this does not mean that the broker trades against you. It just aggregates all clients orders and combine them into one order which is then sent to a stock exchange or hedged otherwise By doing this the broker allows you to access the markets cheaper and faster. On the other hand, you should be aware that the deal is between you and your broker. In this case, if the broker bankrupts you will have to seek your money from the broker, i.e. you do not own the shares.

Finally, you should carefully estimate what can be considered as an advantage especially for you according to your trading style.

Final thoughts

Trading Share CFDs is easier than traditional shares trading in the sense that everybody can quickly start doing it quick and easy by opening an account online and placing orders via electronic trading platform. It is also cheaper and can be done in small amounts. The cons of it are that you do not own the shares, although you have almost the similar rights over them and that you take the counterparty risk against the CFD provider dealing the CFD shares to you.

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Guest post by Peter Traychev.