Traditional trading versus CFD trading
If you are a novice trader you will likely encounter many complicated trading concepts and terms. Concepts like traditional trading and CFD trading will come by. As a newcomer on the trading market this can be quite frightening. You shouldn’t be though, because traditional trading and CFD trading sound more complicated than they are.
What is traditional trading?
If you want to trade, you can do so at the stock market. If you want to trade on the stock market, you can do so with investment firm or a broker. A broker is an intermediary who mediates in the purchase and sale of securities. The definition of trading is that money is put into a certain security for a longer or shorter period with the aim to make profits. There are several ways to trade, the most common of which is traditional trading. An important characteristic of the traditional trading is that you become the actual owner of the relevant security. In addition, with traditional trading you always have to invest the full amount. Traditional trading focuses more on the long term and you can only make money in times of increases prices.
CFD trading is a way of trading that works with CFDs. CFD stands for Contract for Difference, so it is a contract. If you trade in CFDs you are not the contract owner, instead you “borrow” the contract. An important characteristic of a CFD is that it works with a leverage. Because of this leverage you only need to finance a part of the investment. The remainder of the investment is financed by the other party, which is the broker. Because you trade with leverage, you can trade with a larger amount of shares than when you trade in the traditional way. CFD trading focuses more on the short term, you can easily and immediately close the position. Moreover, this way of trading allows traders to make money in both rising and falling markets.
What are the differences between traditional trading and CFD trading?
There are some important differences between traditional trading and CFD trading. Still, traditional trading and CFD trading do have a lot in common, both are types of trading securities on the stock market. With traditional trading the most common security is a share while CFD trading often involves contracts. However, there are important differences between traditional trading and CFD trading. With traditional trading you actually own the security, however, when you trade CFD you don’t become the owner. Another important difference between traditional and CFD trading is that traditional trading is mainly focused on the longer term and you can only make profit from price increases. CFD trading is focused on the shorter term and you can make money from both rising and falling prices.
The main difference between traditional trading and CFD trading is that the latter makes use of leverage.
With CFD trading the investment of the trader is in fact multiplied by a certain factor, which is called the leverage. Because of this leverage a trader can trade with larger amounts. This may still sound a bit vague, and therefore, we will explain the working of leverage in the next paragraph.
How does leverage work?
As said before, with CFD trading you can trade a larger amount of shares with the same money, because your investment is multiplied by a certain factor. We further explain leverage with an example.
Suppose you opt for the traditional way of trading. You decide to invest 200 Euros after which the price rises by 5 percent. Your shares have now become worth 210 Euros. Your profit is 10 Euros. If you decide to trade CFD stocks then there is always a leverage. You again invest 200 Euros, however, due to the leverage you actually buy more. The leverage in this example is 10 and therefore your shares are now worth 2000 Euros. Thus, you can start trading with a greater number of shares. Again, the price increases by 5 percent and your shares become worth 2100 Euros. Your total profit is 100 Euros. You have made 90 Euros more profit with leverage. Because you traded with leverage you traded a larger value which allowed you to make larger profits (of course, your losses could also have been larger; if the price decreases by 5 percent you would have lost 10 Euros with traditional trading and 100 Euros with CFD trading). CFD shares always operate with leverage and the height of the leverage is always indicated in advance. The leverage can be very different, sometimes 1:10, sometimes 1:100.
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