CFDs vs Shares: understand the differences!

Have you ever wondered if you are really buying a share (or any other “real” asset) in your brokerage account? In other words, do you actually own a piece of a company, or is it only a number on your screen?

In our experience, many investors are not fully aware of the differences between owning a CFD and owning a real product, such as a share. Some of them are investing in CFDs rather than in real products without even knowing it.

In this article, we’ll go through the main differences between these two financial products, so that you can make better-informed decisions in the future.

From now on, we will use shares (or stocks) as an example of a real product and CFDs on shares (or stocks) as an example of a CFD.

“Stocks” and “shares” are often used interchangeably, but there is a small difference. “Stocks” is a generic term for ownership in one or more companies, while “shares” usually refers to ownership units of a particular company.

A share is proof of ownership. With a share, you become a part-owner of a company, so you are entitled to any dividends it distributes and to any increase in its value over time. Shareholders usually also have voting rights. It is like owning a piece of your local bakery: if the business goes well, you get your share of the profits, and if it doesn’t, you may lose some or all of your money if it goes bankrupt.

A CFD, or contract for difference, is a derivative that tracks the price of an asset, but you do not own the asset itself. It is a contract between you and the broker, in which the broker agrees to pay you (or you agree to pay the broker) the difference in the asset’s value between the moment you open and the moment you close the contract.

CFDs let you bet on prices going up (long) or down (short), and they are usually traded with leverage. This means you only put up part of the position’s value as margin, and the broker provides the rest. If the price moves against you, you may be asked to add more money, or the broker may close your position automatically when your margin falls below the required level.

Example: you want to buy CFDs on a company whose share price is $100, because you think the price will go up. You open a position of 100 CFDs, worth $10,000. For retail investors in the European Union, ESMA’s rules limit leverage on individual shares to 5:1, so you need a margin of 20% of the position’s value: $2,000 (20% x (100 units x $100)). If the share price falls by 10%, you lose $1,000, which is half of your margin.

Losses can be larger than the margin you put up for a single trade. However, retail clients of brokers regulated in the EU and the UK benefit from negative balance protection, which means you cannot lose more than the money in your CFD account. This protection was introduced by the European Securities and Markets Authority (ESMA) in 2018 and later adopted in national rules. It may not apply if your broker is regulated outside the EU and the UK.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Most retail investor accounts lose money when trading CFDs, and brokers must publish the percentage for their clients.

When you open a trade with a broker that offers both shares and CFDs, check carefully what you are buying. Here are two examples from well-known brokers: eToro and XTB.

eToro

XTB

On eToro, short positions and leveraged positions on stocks are executed as CFDs. A non-leveraged buy position is usually a real stock, but some non-leveraged positions are also executed as CFDs due to product restrictions. Any CFD trade is marked “CFD” in the trade window, so check for this label before you confirm your order. In some countries, eToro also offers Stock Margin, which lets you buy real stocks with borrowed money.

On XTB, you can clearly choose between buying the underlying asset (the real share) and trading a CFD on the same company (Unilever in the example) before placing an order.

Spreads, commissions and currency conversion fees may apply when you buy or sell either a real share or a CFD. So, what extra costs come with CFDs?

The main one is the overnight fee (also called overnight funding or swap). Because a leveraged position uses borrowed money, you pay interest for every night you keep the CFD open. The rate is usually a benchmark interest rate plus the broker’s markup, and it changes over time. Weekend fees are often charged at three times the daily rate.

Here is an illustrative example, using a hypothetical annual rate of 8%:

• Position value: $2,000 (8 shares at $250 each)
• Holding period: 1 night
• Overnight fee: 8% / 365 per night

Result: (0.08 / 365) x 8 shares x $250 = about $0.44 for each night you hold the CFD. The actual cost depends on your broker’s current rates and on the share price, so check your broker’s fee page before trading.

CFDs are like a tool that can be used well or badly. Without leverage, a CFD gives you similar price exposure to the real share, before fees. With leverage, gains and losses are multiplied.

The danger often starts when you place an order. For example, you may invest $100 thinking that it is your maximum exposure, when in reality that $100 is only the 20% margin. With 5:1 leverage, you would be exposed to $500 instead of $100, and a 20% price drop would wipe out your entire $100 margin.

Always check all the order details before placing a trade.

CFDs can be useful for specific purposes, such as going short, increasing exposure with leverage, accessing a wider range of markets or hedging a portfolio. However, they are much more complex and risky, so they are designed for experienced traders and usually for short-term trades.

For long-term investors and beginners, buying real shares is usually the more suitable option. Without leverage, you don’t pay overnight fees, which can significantly reduce your returns over the long term, and you own the asset.

If you remember only one thing: with CFDs, you don’t own any asset and you usually use leverage. With shares, you own a piece of the company, in the same way you own your bicycle or your car.