These days, a trader doesn’t have to limit their opportunities to Forex trading only. Most of the Forex trading companies will also provide stocks, commodities and equities trading all in one place. By offering assets like stocks to individual traders, we can now diversify our portfolios to include a variety of assets and hedge against risk. However, these assets also come with different rules from the regular currency pairs offered, and these rules affect commissions, swaps and spreads. In order to become profitable when trading such assets, one needs to be aware of the differences so they can anticipate the changes and not get surprised. Today we are going to look at each of these aspects in detail regarding stock trading in particular to help you better understand exactly what you’re getting yourself in to. By the end, you should be able to understand the differences between brokers so you can choose the most ideal broker and also to help you determine if stock trading through Forex brokers is suitable for you. (Ask yourself: Should You Invest In CFDs Or Stocks To Make More Money?)
How do Forex traders offer stock trading?
Perhaps we should start from the beginning, explaining how Forex brokers are able to offer stock trading to retail traders. It is only then that we can go into further detail about the inner workings of the system. The story of CFDs dates back to the early 1990s when the tool was invented for use in equity swaps. Later on as trading technologies became more advanced and traders could view live market quotes online, CFDs were then spread all over the world. The improvement in trading technology had a lot to do with the spread of CFDs when you think about how they actually work. Contracts for difference (CFDs) are exactly as their name suggests – contracts rather than assets. Instead of actually buying a company’s stock, a CFD simply tracks the difference in price between the opening and closing prices. (Read about the: Basics of stock trading)
In the past, this was difficult to do because live market quotes were not so accessible except by calling the broker. Fortunately, nowadays market quotes can be viewed online through various trading platforms and even the exchanges themselves. For a Forex broker intending to offer CFDs for stocks, the feature is as simple to provide as keeping track of various stock exchange’s live price quote feeds and forwarding them to clients through Forex trading platforms. Therefore, when watching the live price charts for stocks, it should represent the same feeds as those coming from the stock exchange. (Here is: Everything You Need To Know About The cTrader Forex Trading Platform)
A single broker can keep track of the feeds from multiple stock exchanges to provide even more stocks to their clients… as many as they can handle and stream to their clients. However, the Forex broker would need to be a designated market maker partner with such a party. Most major exchanges do not allow individuals or even financial institutions to buy stocks directly. In the case of, say, the NYSE, a designated market maker (DMM) is the party who has access to the actual live quotes. A Forex broker would thus have to become a DMM or partner with one if they intend to get actual market quotes. (This is: How to trade on the NYSE)
What made the CFDs so attractive to traders and brokers?
Seeing that CFDs have become so popular around the world, it is only natural to wonder why this instrument has become so attractive. To see why this is so, we have to look at it from the perspectives of both the traders and brokers. The broker’s perspective is obvious – more profits. In the coming sections, we shall look at how brokers make money out of providing stock CFDs. To the Forex brokers, stock CFDs are just an additional instrument they can offer to their clients and create a separate avenue for making profits. Besides, a broker can set themselves apart from the competition by offering some stock CFDs that others don’t. (Investor Tips 2019: What To Include In Your Portfolio)
As we have explained previously, a broker can partner with as many exchanges as they can handle and receive market quotes for various stocks around the world. A broker who wants to become different from another could offer a lot more stocks than another broker, and this would make them more attractive to potential customers. FX agents are often known to advertise their high number of stock CFDs alongside their other CFDs in indices, commodities, etc. as a way of marketing themselves.
From the perspective of the traders, stock CFDs offer some clear advantages over regular stocks. The main difference is in the provision of leverage, which allows a trader to purchase and control a lot more value in stock than they would afford. Stock exchanges also provide leverage for the trading of actual stocks, but the amount of leverage is much lower than that made available for stock CFDs. When trading major stocks like Microsoft, Apple, etc., a broker usually requires only a 5% margin while less known stocks would require about a 10% margin. This is a very low margin compared to that required by a broker to buy the actual stock. (Concepts Every Trader Should Understand: Leverage, Margin And Hedging)
For a comparison, consider a hypothetical stock worth $100 per share with a minimum requirement of 100 shares. To buy these shares, one would need $10,000 to buy the minimal amount of shares, and that is before the commissions and other charges. Stock CFDs requiring a 5% margin would, on the other hand, only need you to use $500 and still buy the same number of shares. Not only do you need less money, but the profits are also much higher. Suppose the stock price rose to $120 after a few days; the trader who bought actual stock would make $20 per share, hence a total profit of $2,000. For the stock CFD trader, though, they would make a lot more profit considering that they only put up $500. (These are the: 10 rules of how to earn money with scalping)
Another advantage of stock CFDs over conventional stocks is the access to multiple markets from a single point. To buy actual stocks from all over the world, that would mean working with numerous brokers. For example, having one for the US markets and others for the European, Asian, Australian markets, etc. However, a single Forex broker can open up multiple markets simultaneously providing a lot more access to the stock markets. Also considering that stock exchanges are opened at different times of the day in different time zones, one could theoretically trade stock CFDs 24 hours a day, just as they would the Forex market.
There is also the advantage in shorting CFDs that isn’t readily available in the stock market - ease. For decades, some economists have argued against shorting stock markets because it was ‘unethical’ to hope for the demise of a company. Fortunately, this sentiment has not taken over the markets as most economists argue that shorting keeps the stock value of companies in check from runaway overvaluation. However, the controversy around shorting stocks has led to the implementation of restrictive rules around shorting. For example, in certain times shorting may be restricted by an exchange to prevent prices from bottoming out. (Learn more about the: Growth Of The Forex Arena In Africa And Other Developing Countries)
Additionally, exchanges require a much higher margin for shorting. In order to short a stock, it involves ‘borrowing’ the stock from someone who has it and then selling it current market value. Afterwards, when the stock’s value decreases, you can buy the same number of shares at the lower market value and return then to the person you borrowed them from in the first place. Because a person shorting actual stocks has to borrow them, they are required to provide a higher margin as an assurance they shall return them to the lender. In a stock exchange, the lenders of stock to short are usually the supplemental liquidity providers (SLPs) who are required to accept all orders (buy and sell) just to maintain liquidity in the markets. (In case: You Wanted To Know How Many Traders Lose, Now You Know)
Furthermore, there is also the danger that a short position can lead to incalculable losses if the trade goes wrong. Think of it this way – if a company’s stock price goes down to the floor, the maximum possible loss is the initial value of the stock. If you hold a short position, though, and the stock price goes up, it could continue to go up theoretically forever causing increased losses henceforth. This risk also demands assurance, and this is in the form of a higher margin.
In short, trading stock CFDs is simply much easier in so many ways to the trader that it is unsurprising that their trade became so popular. Because brokers have no option but to provide what their clients want, stock CFDs just became more and more popular over the years until today. For the brokers, it didn’t hurt their bottom line since it was just an additional avenue for making money and what’s more, beating their competitors. (Can You Actually Get Your Money Back From A Fraudulent Dealer?)
Downsides to trading stock CFDs
Inasmuch as CFDs have so many advantages to the traders and brokers, they aren’t without their own downsides. One of the most serious has to do with the very structure of CFDs. Since CFDs are just contracts, they can only work if both parties can honour the contract even when they have lost. Naturally, this market has attracted scam brokers who were only interested in running away with their clients’ money. Indeed, some economists have compared CFDs to the bucket shops that were run in the US during the early years of the stock market. Bucket shops were just scam shops where unsuspecting traders thought their orders were being relayed to the stock exchanges, but they were only having their money stolen.
As the CFDs market is decentralized, there can be no recourse to trace the perpetrator once they have already absconded with your money. In a normal stock exchange, margin is put down to ensure that every participant honours their contract, and the exchange itself would normally cover any reneging parties. Therefore, it is very important to ensure that the broker providing the CFDs can be trusted. (These are the: Top 10 Most Outrageous Forex Arena Scammers)
Yet another downside to trading stock CFDs has got to do with the use of leverage to buy the assets. As we already saw, leverage can be very beneficial in that it helps a trader to make a lot more profit than they normally would. At the same time, the same leverage can cause massive losses, which is why they say leverage is a double-edged sword. For example, let’s continue with the previous example of a stock valued at $100 and a minimum requirement of 100 shares. Had someone shorted the stock CFD of this stock with a margin of 5%, they would only be required to put up $500. Unfortunately, it would only need the stock price to decrease by $5 up to $95 to wipe off the entire margin. Just after the stock price reached $98, the trader would receive a margin call from the broker and perhaps even be stopped out. If the stock price were to continue going down, then the entire account could even be wiped out and, worse, leave the trader with a negative balance. As a result, anyone trading CFDs in stocks should be very careful when using leverage to avoid any huge losses to their account balance. (Lessons on self-defense: Forex scams)
Regulations regarding CFDs
The problems with stock CFDs have a lot to do with regulation or lack thereof. The CFDs market is decentralized in that anyone around the world can set up such a contract without having to go through a stock exchange. As mentioned before, this has led to the creation of a lot of scam brokers who only create fake CFDs to cheat their clients. All the same, financial regulators have been trying to curb such cases by imposing regulations on the CFD market. Previously, there was only minimal regulation in the markets causing increasing cases of fraud. That is why in 2016, the European Securities and Markets Authority (ESMA) issued a warning about trading by retail traders. This was after the regulatory body received an increasing number of complaints by individuals who had been scammed while trading in stock CFDs. Then ESMA later passed specific regulations to guide the CFDs market as shown in the image below. (ESMA Finally Puts Its Foot Down On MiFID II Regulations)
One of the main things that the new regulations addresses is the high level of leverage that was previously available. Some Forex brokers offer as much as a 200:1 leverage for these products, and that caused huge losses to unsuspecting clients. Had a trader used this high leverage and put up a huge margin, then their account could have suffered a huge loss if the stock price decreased by a huge difference. That is why ESMA placed a 5:1 leverage cap on individual equities to limit the amount of losses any trader could experience. (Forex Rigging And Manipulation: How The Major Investors Pull It Off)
Remember when we mentioned that CFDs trading had spread across the world? Well, one area that seems to have been skipped was in the US. When the Dodd Frank Act was implemented in 2011, another area affected other than the Forex market was the CFDs market, whereby these instruments were banned from trading by individual investors. According to the law, trading of CFDs is only allowed through a registered exchange and not over the counter as in other areas in the world. The bad news is that there are still no CFD exchanges in the US, effectively rendering the industry dead in the country. (Can A Forex Broker Avoid Sending Trades Directly To The Interbank Market?)
Trading of CFDs over a registered exchange was attempted before when the Australian Securities Exchange (ASX) issued exchange traded CFDs between 2007 and 2014. In the end, these centralized forms of trading CFDs were ultimately called off because the costs were higher than over the counter trading. To increase the security of trading these products, the ASX had to demand a higher margin, and this was just infeasible for trading by individual traders. (Is It Time To Upgrade To Metatrader 5: Features Of MT5)
Something else to consider is the taxation of profits gained from trading these products. When CFDs were launched in the UK, the FCA considered these tools as actual investment tools, imposing a tax on their trade. Other unique products like spread betting and binary options are considered a form of gambling and are thus not taxed. However, CFDs are bound by capital gains tax, which varies from one country to another, and every trader of these products must be aware of the regulatory environment in their location. (Do you know: How Is Spread Betting Different From Forex Exchanging?)
Explanation of various terms involved in trading stock CFDs
If you’re planning to trade these products, it is important to know exactly what is involved in these markets. When it comes to stock CFDs, there are three basic aspects one has to think about and these have been discussed below:
In case you’re wondering how the Forex brokers benefit from this, the answer is the same as that of the Forex market – spreads. A spread refers to the difference between the buying and selling prices, and it is how the broker makes money after providing stock CFDs to their clients. Remember that the broker does not provide any actual stocks to their clients, so the only way to make any profits would have to be through the application of a spread. To understand how a spread is applied, it’s best to take an example from an actual market situation. For example, the share price of Amazon at this time is $1,617.21 according to Google. Yet the Forex charts online below provided by HotForex brokers shows that the bid price for this stock is $1,614.96, meaning that the spread is about 4.50 ((1617.21 - 1614.96) x 2).
Clearly, the spread by this particular broker for stock CFDs is much higher than that on Forex pairs, but that is what the brokers must do. As we already mentioned before, a Forex broker who wants to offer CFDs for stocks must be a DMM or partner with one, so they must pay an extra fee to receive the live quotes. The chart below represents the spread values from XM.com brokers, who are among the most popular Forex brokers in the world. The image below shows that XM.com offer spreads for trading Amazon shares as low as 3.25, which is lower than that provided by the broker above, but not by too much. (These are the: 7 Powerful Candlestick Patterns to Learn and Understand)
Just like in the Forex markets, spreads for stock trading through a Forex broker vary from one moment to another depending on the volatility in the stock market. Some of the volatile moments in the stock market include the release of earnings reports, changes in management or the effect of stock markets in general. As an illustration, there was a massive selloff in the stock markets following the US presidential elections and extended selling toward the end of 2018 when the overall US equities were decreasing in value. (These are the: Best technical indicators and how to use them)
Obviously, you would want to work with a Forex broker providing stock CFDs at the minimal possible spread to save money. Especially if you are going to be making regular trades, it is essential to find the smallest spread. All the same, the spread from both of the brokers above HotForex and XM.com is very affordable considering that the share price of Amazon shifts by about $50 every day on average. With a spread of between 3 to 5, it is thus possible to make daily trades and still make good money. That makes stock trading even for an intraday trader profitable and suitable. (Revealing Forex Bonuses Of Brokers: How To Identify A Real Bonus)
Apart from the spreads, Forex brokers can also apply commissions in addition to the spread already charged. The choice to add a commission to trading stock CFDs depends on the Forex broker, but the most popular brokers do not add a commission. Nevertheless, there are still some renowned brokers who charge a commission on every trade in addition to the spread. The commission is usually charged as a percentage of the profits earned from the trade, and the percentage is set by the broker themselves.
The typical percentage for the trading of stock CFDs is about 5%, which isn’t too high when trading any instrument. Perhaps the only downside is that it could increase the losses to a certain extent if the trade ends up in a loss. Nevertheless, the percentage in commission should not greatly affect your account balance. You can also try to avoid paying any high commissions by confirming beforehand the amount of commission charged by your broker so that you know exactly what you’re getting yourself into. Remember that risk management is critical in reducing the potential losses one might make while trading. (Think Twice When Making A Deposit In A Forex Company)
Also just like trading currency pairs, stock CFDs also attract swaps for holding the position open overnight and over the weekend. Swaps are charged because positions are actually never kept continuously open by the broker overnight and through the weekend. Instead, the broker closes the position when the market closes and then re-opens the position when the markets open. With the stock market, this means closing the position when the trading day ends, typically around 5pm in the location of the stock exchange. When the broker moves to re-open the position when the exchange once again resumes trading, a swap is charged instead of an additional spread to open the position at the previous closing price. That is why swaps are charged for trading stock CFDs just like currency pairs. (Learn: How Not To Be Added To The 95% Of Losing Traders)
The same picture above representing charges by XM.com shows the value of these swaps clearly as split between long and short positions. The webpage does not indicate the difference between short and long positions, but we can presume these are indicative of overnight and weekend swaps. The swaps for these are 1.29% and 4.71% respectively, meaning that your profits are deducted according to these percentages depending on whether you are holding the position for a short or long period of time. (All you need to know about: Risk-management on Forex)
For those of you wondering if trading stock CFDs can be profitable, just watch this short clip: