CFD vs. ETFs: Differences, Similarities, and Which to Choose

CFDs and Exchange Traded Funds (ETFs) are two of the most popular instruments you can trade as an investor in the financial markets. With each instrument, you have access to a diverse range of markets, and unlimited trading opportunities.

Compared to each other, CFDs and ETFs have their own benefits and drawbacks. Let’s look at these two instruments.

Key Points

• CFDs offer high leverage and diverse market access without owning the underlying asset, while ETFs provide lower-risk investment in a basket of securities with actual partial ownership.
• Both CFDs and ETFs allow trading across various markets with high liquidity and leveraging options, yet differ in asset ownership and trading platforms, with CFDs being over-the-counter and ETFs on centralised exchanges.
• CFD trading is suitable for those seeking to capitalise on market movements using leverage and short-term strategies, whereas ETFs are preferred for lower-risk, diversified, and transparent investments.

CFD vs. ETF: Which is Better?

A CFD is an instrument to consider trading if:

• You want to trade on margin or leverage
• You want to trade over the counter
• You want to trade a diverse range of assets
• You want to hedge your portfolio
• You have no interest in owning the underlying asset
• You have a high appetite for risk

Exchange Traded Fund (ETF) are financial instruments to consider trading if: 

• You want to own the underlying asset (at least in part)
• You prefer low-risk investments
• You want to hedge your portfolio
• You want to trade a diverse range of markets
• You prefer markets with more liquidity

Similarities Between CFDs and ETFs

1. Flexible Underlying Assets

You can use both CFDs and ETFs to trade a diverse number of markets. That includes stocks, commodities, currencies, and indices. You can find specific ETFs for particular asset classes, countries, sectors of the economy and even geographical regions on a trading platform. 

2. Leverage

Both ETFs and CFDs allow you to trade on margin and use leverage. In the case of CFDs, your broker provides the leverage. In both cases, leverage can magnify your profits or losses. In some cases, your losses may even exceed your invested capital.

3. Hedging

You can use both ETFs and CFDs to hedge other positions in your portfolio. For example, buying the Inverse S&P 500 ETFs can be an excellent way to hedge your stock positions since this ETF generally moves opposite to the stock market.

CFDs are a superb instrument for hedging, primarily because you can use them to potentially offset losses in your portfolio using leverage.

4. Liquidity

Both CFDs and ETFs have high liquidity in their markets. With ETFs, they are similar to mutual funds but are able to trade like stocks which makes them more flexible and convenient for investors to buy and sell. That means there are plenty of buyers and sellers in the market during trading hours, and you can get into or out of positions fast.

CFD trading are usually done over the counter, and most brokers have liquidity providers. That also means you can sell a CFD short or buy a CFD long at any time.

5. Spreads

Both CFDs and ETFs incur a spread. The spread is the difference between the bid price and the ask price.

6. Trading Periods

Unlike assets like futures contracts which expire, you can trade ETFs and CFDs for as long as possible. You can also trade them over short periods (days and weeks) or long periods (months and years).

Differences Between CFDs and ETFs

1. Asset Ownership

The most fundamental difference between CFDs and ETFs is asset ownership.

If you purchase the CFD of a particular asset, you don’t own the trading instrument. Instead, you only trade the price movements of that underlying asset.   

The CFD you purchase derives its value from that underlying asset and allows you to make a profit or a loss based on how accurate your predictions are about the price movements.

On the other hand, when you purchase an ETF, you own a small part of the multiple stocks that it consists of. For example, if you’re going to buy the FTSE 100 ETF, you gain exposure to the entire FTSE 100 Index with just a single position, and by extension, exposure to stocks such as Shell, Unilever, Diageo, and GSK.^[1]

2. Market Access

You can trade CFDs over the counter (OTC). However, to trade an ETF, you’d have to take a long or short position on it from a centralised stock exchange. ^[2]

In the case of CFDs, you trade against your broker, and often, they are the counterparty to all your trades. CFDs aren’t listed in formal exchanges, and OTC trades occur only between only two parties.

CFDs only have a single buy and sell price, unlike centralised exchanges that offer multiple price options across both the sell and buy sides.

ETFs are highly regulated investment fund.. For this reason, they’re easily found and traded on stock exchanges. Stock exchanges allow both individual and institutional investors to participate in trades on a public venue.

ETFs often follow an order flow, transparent pricing, and market makers control the bid-ask prices to keep the markets fair.

In the case of ETFs, your broker only acts as an intermediary between you and the markets.

3. Financing

You can trade CFDs on margin, but most times, trading ETFs means owning an actual part of the fund.

Since CFDs are a derivative product, you can enjoy massive upside (or downside) and control a much larger position with relatively lower capital. Typically, you’ll need to meet a margin requirement of about 5 to 10% of the underlying asset’s value.

ETFs are slightly different in this regard. Although you can trade leveraged ETFs, the leverage isn’t always significant. Most times, you’ll still need to cover the full cost of the ETF.

4. Risk Profile

CFDs have a higher risk profile than ETFs, but they also have a higher potential for trading opportunities.

CFDs can be volatile. That means you can go from a winning position to a losing one fast. Using leverage, you may also lose more than your invested capital. However, if you use a sound trading strategy and make accurate predictions, you can potentially take advantage of market opportunities with your invested capital.

In comparison to CFDs, ETFs have a different risk profile. They incur lower cost, and hold a basket of securities – which increases your diversification.

5. Costs

Compared to other instruments, ETFs can be cheaper. However, you may pay more costs to trade EFTs than CFDs. 

Some costs associated with ETFs include:

• Commissions
• Spreads
• ETF Expense Ratio
• Management Expense Ratio (MER) ^[3]

These costs can be quite high for investors, especially with limited capital.

In comparison, CFDs pay:

• Commissions (Except in forex CFDs)
• Spreads
• Financing costs
• Holding fees for overnight trades

Benefits of Trading CFDs Over ETFs

1. You Don’t Own the Underlying Asset

• CFDs are derivative products. They only mimic the underlying asset, but do not represent ownership of any actual asset. For this reason, trading CFDs requires little capital, which lowers the barriers of entry for investors and traders. In addition, swing trading can be used as an effective strategy when using CFDs. As swing traders aim to profit from short-term price movements, the low capital requirements of CFDs make them an attractive option for this type of trading. 
• There’s usually no minimum investment size needed to begin ETF trading. However, you’ll pay for an actual asset, which means you will end up owning one (or more) shares of the ETF.
• If you’re looking to take advantage of price movements without having to own tangible assets then CFDs could be an option to consider.

2. Access to Leverage

• Most CFD brokers give you access to leverage. With limited margin, you can still open and trade a sizeable position.
• Despite the risk of losses that exceed your invested capital, leverage has the potential to magnify your potential returns, primarily if you use risk management strategies and make accurate market predictions.^[4]
• You can trade leveraged ETFs with similar efficiency as CFDs, but that comes with two disadvantages. ETFs offer lower leverage than CFDs, and you may still have to pay the full cost of the asset in some cases.

Final Thoughts

If you’re not interested in owning any assets, then online CFD trading could be an option for you to consider. That way, you can take advantage of the price movements of the asset without worrying about bull or bear markets. However, if you’re looking to invest long-term, then ETFs are the way to go.

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References