What is the Difference Between Stock Ownership and Stock CFDs? (For South African Traders)

Introduction 

CFDs, or Contracts for Difference, are contracts that allow traders to speculate on price movements of an underlying asset without buying the asset. The value of a CFD is determined from the price shifts of the asset. 

CFD contracts bind trader (“buyer”) and financial broker (“seller”) into an agreement to speculate on whether the asset price will fall or rise. CFDs can be linked to various underlying securities, such as stocks, stock indices, currencies, commodities, or even CFD cryptocurrencies. 

Understanding CFD Trading: Leverage and How It Works 

CFDs are traded with leverage, it allows traders to hold larger positions with even with small capital. Trading CFDs is not owning an underlying asset (physical share, forex trading or commodity). It involves buying or selling the contracts based on that asset’s price movements.  

Advantages of Using CFDs 

One of the biggest advantages of CFDs is that they give traders unlimited trading opportunities. You can trade CFDs for almost every asset class.  a few of them are listed here: 

Single stocks 

Forex 

Stock indices 

Commodities (metals trade, energy, etc) 

Bonds 

Options 

Cryptos 

CFD trading enables traders to trade on leverage, meaning you only need to deposit a small percentage of the full value of the trade to open a position. This is called ‘trading on margin’ (or margin requirement). Trading on margin allows you to increase your returns but it also increases your potential losses based on the full value of the position. 

Leverage is applied in multiples of the invested capital, such as 2x, 5x, or higher, with the broker lending the additional amount at a fixed ratio. Leverage can be used for both long (buy) and short (sell) positions. However, it should be kept in mind that where leverage maximizes potential profits, it also gives exposure to potential losses.   

CFD trading generally offers higher leverage as compared to other trading methods the margin ratio depends on the asset and broker. Lower margin means traders get less capital upfront while potentially achieving greater returns, however, this carries higher risk. 

CFDs allow traders to go short (sell) if you predict its price will fall and aim to profit from the downward price movement. If your prediction turns out to be correct, you can go long (buy) at a lower price to make money out of it. If your prediction was wrong and the price rises, you will make a loss on your trade. 

CFDs trade over the counter (OTC) through a network of brokers that determine the market’s supply and demand and set the prices accordingly. They are not traded on major exchanges such as the New York Stock Exchange (NYSE) as they are a tradable contract between a client and the broker, who are exchanging the difference in the initial price of the trade and its value when the trade is closed. 

Mostly CFD trades have no expiration date, meaning the contract is unlimited. A trade is closed only by placing an opposite trade, for example, a buying position of 100 CFDs on silver can only be closed by selling the same 100 CFDs.  CFD are traded as "lots".  The size of each contract varies depending on the asset, like how that asset is traded in its market.   

What are the different features of CFD trading and stock trading? 

Hedging your physical portfolio with CFD trading 

If you have already invested in physical shares and fear of them losing value in short term, you can use CFD hedging. It involves short selling the same shares as CFDs and making profit from the downward price movement to offset the potential loss. 

For example, you have Apple shares, you could hold a short position or short sell the same value of your stocks with CFDs. If Apple’s share value goes down, the loss in value of your physical share portfolio could potentially be balanced out by the profit made on your short-selling CFD trade and then rule out your CFD trade to secure your profit as the value of your physical shares start to go up again. 

Popular Stocks and Sectors in South Africa  

There are a wide range of stocks traded on the Johannesburg Stock Exhange (JSE) including the following:  

• Naspers is an internet technology and media company headquartered in Cape Town with investments in global tech companies.  
• MTN Group is South Africa’s leading telecommunications provider among the world’s top network providers.   
• Sasol is an integrated energy and chemical company based in South Africa  

South Africa’s economy divided in sectors   

Mining is the core of the South African economy including commodities like gold, platinum, and coal.  

Telecommunications includes big names like MTN and Vodacom  

Financial Services includes banks like Standard Bank, FirstRand, and Absa Group.  

Profit and loss 

To calculate your profit or loss earned from a CFD trade, total number of contracts by the value of each contract. Then multiply that figure by the difference in points between the opening price and the closing price (of the contract). 

When the contract is closed you will receive or pay the difference between the closing value and the opening value of the CFD and/or the underlying asset(s). If the difference is positive, the CFD provider is obliged to pay you. If the difference turns out negative, you are obliged to pay the CFD provider. 

Traders should only consider trading in CFDs if they wish to speculate or hedge against exposure in existing portfolio or if they are experts in trading in volatile markets and have huge risk appetite.  CFDs are not suitable for ‘buy and hold’ strategy as they need to be monitored constantly, almost all the time. Even holding your investment overnight exposes you to greater risk and additional costs. The leverage and stock market volatility can lead to rapid price shifts in your overall position requiring you to act quickly to manage risk. 

Like any other investments, CFDs also carry risk. The major risk of any trading is the market price risk. If the market moves in the direction you traded, you will make money, if it moves against you, you will lose money. However, leverage in CFDs can cause higher risks so it is best to use leverage with caution.   

Ownership or Stock CFDs?  

Whether you are investing for ownership or trading CFDs, the choice depends on your trading style. You should assess your financial goals and risk tolerance before making the decision.  For instance, if you purchase shares of Naspers or MTN on the JSE, you will own a piece of the company. If you trade CFD on Sasol, you will speculate on its price shifts without owning the actual shares.