Throughout history, share trading occurred on trading floors – referred to as the pit. Even if you’ve never been to the famed trading pits, chances are you know what they look like, and thanks to Hollywood, sound like. Since the early ‘90s and 2000s, however, the arrival of electronic trading platforms largely displaced pit traders of old, along with its legendary form of communication: Open Outcry. In 1971, the Nasdaq stock exchange set out to establish the world’s first electronic stock market.

Nowadays, stock trading (or equities trading) is largely accomplished in two primary ways. One option is purchasing shares of a company on an exchange through a share dealing account, effectively becoming a part-owner. The alternative is through the derivatives market, using CFDs, or contract for differences.

CFD trading has continued to grow in popularity over the past 20 years amongst retail private investors. CFDs are leveraged trading products that mirror the price movement of an underlying asset, which in this case is the share price. It’s an agreement, or contract, between buyers and sellers to exchange the difference between the opening and closing price. In most cases, an individual CFD contract is equivalent to one share.

Leverage

Leverage, also known as margin trading, provides increased exposure with a small outlay, though leverage is a double-edged sword. While greater returns are possible, there’s also increased risk of large losses that may extend to more than your deposit. Margin is usually expressed as a percentage of the position’s notional value – a portion of your account is set aside by your CFD broker to ensure you have the means to cover any potential losses.

When purchasing shares outright, that is if you want to own $10,000 worth of Facebook, Apple, or Google, for example, you’ll need $10,000 in your account, plus commissions. A margin facility is available in the stock market – you usually borrow from your broker in exchange for interest paid on the securities. Typically, traders are able to borrow 50% of the stock’s purchase price.

CFDs are also traded on margin. To open and maintain a CFD position using leverage, an initial margin is required. If the initial margin for a stock CFD is 10%, for instance, the trader would need only put up $1,000 of the position’s value ($10,000). Leverage rates in the CFD market depend on the financial instrument traded. Leverage for Forex (think currency pairs), indices, and commodities, though, can be as high as 1:500. That’s quite a contrast to the 1:2 ratio offered in the stock market.

Direction

Through a traditional stock brokerage, short selling stocks (sell falling markets – a short position) can be difficult. The action involves borrowing shares from your broker, selling them on the open market with the intention of buying the shares back at a lower price. Once the trade is liquidated, the borrowed shares are returned – the broker charges for this service.

With CFDs, as well as other derivative products, such as futures and options, CFD traders can easily participate in both directions as CFDs are contracts – there is no ownership of the underlying shares.

Rights

Acquiring company shares gives the holder the right to a share in the company’s income and assets. Company shareholders may also receive dividend payments. Pre-emptive rights are another aspect worth highlighting. This gives the shareholder the right to buy additional shares of a company’s stock before being made available to the general public. While it is still possible to receive stock certificates, Investments are largely held in what’s known as ‘nominee accounts’ at your brokerage – Street Name Registration. The investor is the beneficial owner though it does not appear on the shareholder register, the broker does.

In terms of CFDs, shareholder rights are obviously limited as the asset never changes hands. Positions, however, are adjusted to offset changes from dividends. Dividend debits and credits are an important consideration, particularly with respect to long-term CFD positions.  A dividend credit is received when long a CFD contract, though short selling a market can bring with it a dividend debit.

Additional Points

• For UK equities, if you purchase shares in a UK company, traditionally there’s stamp duty to pay off around 0.5% on the transaction. With contracts for differences, as you’re not trading physical shares, CFDs are exempt from UK stamp duty, although profits are still subject to capital gains tax.
• CFD providers, or CFD brokers, grant access to global markets, whereas traditional shares are limited to equities only.
• For trading hours of CFDs, refer to your contract specifications tab on MetaTrader 4 (MT4). For physical shares, trading is permitted at exchange opening times.
• Leveraged CFD contracts provide the opportunity to hedge against an existing stock portfolio.

If you’re looking to purchase shares and hold long-term, buying physical shares may be the more optimal path to explore. For short/medium-term traders, such as day trading, for example, trading CFDs are an option.

DISCLAIMER: The information contained in this material is intended for general advice only. It does not take into account your investment objectives, financial situation, or particular needs. FP Markets has made every effort to ensure the accuracy of the information as at the date of publication. FP Markets does not give any warranty or representation as to the material. Examples included in this material are for illustrative purposes only. To the extent permitted by law, FP Markets and its employees shall not be liable for any loss or damage arising in any way (including by way of negligence) from or in connection with any information provided in or omitted from this material. Features of the FP Markets products including applicable fees and charges are outlined in the Product Disclosure Statements available from FP Markets website, www.fpmarkets.com, and should be considered before deciding to deal with those products. Derivatives can be high risk; losses can exceed your initial payment. FP Markets recommends that you seek independent advice. First Prudential Markets Pty Ltd trading as FP Markets ABN 16 112 600 281, Australian Financial Services License Number 286354.