Stocks vs CFDs: The Key Differences
Updated 8 November 2020
Investment in stocks has a long-standing reputation for the potential to earn big returns for those who can navigate the ups and downs of the trading markets. An investment opportunity that is becoming increasingly popular, however, is the use of CFDs (Contract For Difference).
Where purchasing stocks in a business means that you own that stock, a CFD simply matches the value of a stock or commodity without the element of ownership.
If you think a course in trading might benefit you, read The Best Stock Trading Courses.
Key Differences Between CFDs and Stocks
Both stocks and CFDs are viable trading options but there are key differences between the two investment opportunities:
What Do You Own?
This is the main key difference between CFDs and stocks. When you purchase stocks, such as shares in a business, you own those stocks until you sell them.
With CFDs, there is no element of ownership. What you have instead is a contract with a broker.
The advantage of ownership, in this context, is the related range of shareholder perks and benefits; for instance, voting rights or the option to attend shareholder meetings.
Another benefit of stock ownership is the payment of dividends.
If you purchase CFDs in relation to company shares, the likelihood is that you will be paid a dividend if you have a CFD in place at the time when dividends are released to shareholders.
However, the conditions surrounding that dividend, such as the amount paid out, will vary from the dividend arrangement for a stock holder.
Financing the Investment
Once an investor in stock has spent their investment pot, they cannot make new purchases without the sale of their existing stocks.
James and Michael each have $10,000 to invest.
James uses his $10,000 to buy 25 Tesla shares prices at $388 each, leaving him with $300 unspent.
Michael is also interested in Tesla, but instead of using most of his money in a straightforward stock purchase, he arranges a CFD with a 10% margin. He invests $970 and borrows the rest of the money from his broker. Michael then has $9,030 remaining to invest elsewhere.
To find out more about Leverage Trading, read What Is Leverage in Forex Trading?.
What Can You Invest In?
If you invest in stocks, you are generally limited to purchasing business shares or exchange-traded funds (ETFs). An ETF is a collection of securities that are traded on an exchange.
Speed of Cash Settlement
Should you sell all or a portion of your stocks, you can expect to wait at least a couple of days before you receive the cash settlement.
However, when you sell your CFD or it comes to an end, you will be paid immediately. The benefit to an immediate cash settlement is the speed with which you can reinvest your money or take it as income.
If you invest in stocks, your trading will be limited to stock exchange hours. This is generally from 9:30 a.m. to 4:00 p.m. Monday to Friday.
Stock exchanges are closed for trading on a weekend and during certain holidays.
If you invest in CFDs, however, which are open to a wider range of investment instruments (forex, commodities, etc.), you have access to many more markets.
This means that you can generally trade for twenty-four hours every day.
Length of Investment
Your decision to invest for a short length of time (be that hours or days) or on a longer basis (stretching from weeks to even years), will inform your choice of stocks or CFD investment.
CFDs can be used for short or long-term investments, but are especially suited to short term because many of the investment instruments they trade in, such as cryptocurrency or forex, are subject to rapid rises and falls in price.
By comparison, stock trading is not suitable for short-term investments because it relies on a buy-and-hold strategy, and restrictions linked to actual ownership of stocks which may prevent a quick sale.
The handling of trading profits, whether by stocks or CFDs, is generally the same in the US. Trading profits are subject to capital gains tax.
Short-term capital gains tax is paid on the sale of assets that you have owned for up to and including one year.
When paying short-term capital gains tax, your ordinary income tax rate will be used.
CFDs will generally be subject to short-term capital gains tax, because of the extra fees they incur if held long term.
Long-term capital gains tax applies to assets that you have owned for longer than one year. The capital gains tax rate you will pay depends on your income for that tax year:
- If you earn $40,000 or less, the tax rate is 0%.
- For an income between $40,001 and $441,450, the tax rate is 15%.
- Finally, for an income over $441,450, the tax rate is 20%.
If you receive qualified dividend payments in relation to stocks that you own, this will generally incur a tax liability.
A qualified dividend meets the following criteria:
- The dividend payment is made by a US corporation or a foreign entity whom the IRS recognizes as qualifying.
- It is recognized as a dividend by the IRS.
- You owned the stock for a sufficient amount of time.
The tax rate applied to your dividend earnings will rely on your overall income for the year.
- For a taxable income of up to and including $39,375, the tax rate is 0%.
- For a yearly income in the range of $39,376 to $434,550, the tax rate is 15%.
- For income over $434,550, the tax rate is 20%.
Taxation Example One
Jane supplements her employed income through trading stocks and the related dividend payments. Her salaried income is $20,000. She sells stock that she has owned for two years and makes a profit of $19,000.
However, before she sold the stock, she received a qualified dividend payment of $4,300. This makes a total income of $43,300.
A 15% tax rate is applied to her dividend earnings.
Capital gains tax is applied to gross earnings (before deductions are made). Jane’s gross earnings for the year are $43,300. The corresponding tax rate is 15%.
Taxation Example Two
Marie also supplements her employed income, but she uses CFDs. Her salaried income is $10,000. Trading CFDs, she makes a profit of another $10,000. She receives no dividends. Her gross income for the year is therefore $20,000.
As she held the CFDs for less than one year, short-term capital gains tax applies. Her ordinary income tax rate is therefore used.
For an income of $20,000, the appropriate income tax rate is 12%.
What If You Earn All Your Income From Trading?
If you earn all your income from trading, you may find that the IRS tax your earnings via income tax instead of capital gains tax.
Here is an example of how this might make a difference to your tax liability:
Sheila relies on trading for her entire income. In one year, she makes $165,000.
If she were to pay long-term capital gains tax on this amount, she would incur a capital gains tax rate of 15%.
However, if she were to pay short-term capital gains tax or income tax on this amount, she would incur an income tax rate of 32%.
As you can see, the latter option incurs a tax liability of almost double the first.
All of the above calculations are based on current US tax rates in 2020.
Which Is the Best for You?
There is no straightforward answer to this question. It will depend on your personal needs.
Factors to consider include:
Do you actively want to own shares in a business and enjoy the privileges that brings, such as voting powers and dividend payments? In which case, investing in stocks is the path for you.
Are you more, or at least equally, interested in being involved with a particular business over making a profit? If yes, then stock trading is your best choice.
CFDs are your best bet if you want to invest in instruments not available to stock traders, such as commodities or cryptocurrency.
Do you want to make a short-term investment, selling after a couple of days? Again, CFDs are your best choice.
How much money do you have to invest? Using leverage trading, CFDs may give you access to the same opportunities as buying stock but for a smaller outlay of money.
Do you want to be able to trade at any time or are you happy to trade within stock exchange trading hours only?
CFDs vs Stocks: Pros and Cons
If you are still unsure which type of investment will suit your needs, maybe you should consider the benefits and downfalls of each option:
- The option to use leverage investing so you can spread your investment pot
- Can be used for both short and long-term investments
- Opens up a wider range of investment instruments than stock trading
- Higher risk of losing money
- Leverage investment is complicated and can prove difficult for a beginner
- The benefits that accompany stock ownership
- You own the stocks
- Depending on your earnings from trading, stocks investment can be more tax-efficient due to the application of capital gains tax instead of income tax
- Only able to trade when the stock markets are open
- Not suitable for short term investment
The Best Places to Trade Stocks and CFDs
Whether you decide to invest in stocks or CFDs, having a range of places where you can trade them is always useful.
Here are some great options:
IG is a worldwide, award-winning, forex (foreign exchange) trading provider, which has been in existence for over 45 years and is registered with both the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA).
As stock trading does not cover the forex market, this provider is only suitable for CFD trading in this instance.
2. CMC Markets
CMC Markets has operated as a trading provider for over 30 years across a wide range of markets, making it an ideal provider for both stock and CFD investments.
Its mobile trading app, suitable for both iPhone and Android, makes trading on the move an easy option.
Established in 2007, eToro offers both stocks and CFD trading opportunities. They charge 0% commission on stocks trading and, through their patented software CopyTrader, the opportunity to copy the portfolios of top-performing traders.
eToro also features an online community in which you can join discussions with fellow traders and learn more about trading.
4. Plus 500
Plus500 is a UK-based trading provider offering both CFDs and stock trading investment opportunities.
Plus500 offers a free app for trading on the go, which provides a demo mode to learn how to trade before you make an actual investment.
5. City Index
Originally established in the UK in 1983, City Index offers investment opportunities across the stocks, commodities, indices and forex markets.
In addition to its service provision, City Index also offers training videos and tutorials on trading.
Stocks and CFDs are both viable trading options and offer the opportunity to make big profits if handled correctly.
The decision on which to choose will, however, depend on your personal situation, your trading expertise and what you want to achieve in the short or long term.
WikiJob does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. Mediavine
ESMA risk warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.