How to buy and sell shares
Now that you have an understanding of what stocks and shares are, you may ask the question: how do you actually trade shares?
The answer to this question usually depends on how active you want to be as an investor or a trader. Those that want to buy and hold shares for many years can go to a bank, who usually have the means to buy shares. The fees that a traditional bank charge – you are usually charged twice, once to buy and again to sell – are high. The rise in value of those shares over the long term will generally more than compensate for the fees you have to pay.
You can use an online broker to trade more frequently
However, if you want to buy and sell shares quickly, to take advantage of short term price movements, then this method, due to the high cost of trading, will not suit you.
To be more active in the markets, it would be best to trade through an online broker.
It's a fairly straightforward process where you place an order with a broker using a piece of software called a trading platform, and it will execute buy and sell orders on your behalf.
There are two different ways of trading shares
The way you can trade shares has altered in recent years. It used to be the case that in order to buy a share, you would take ownership over the actual share and have that ownership until you sold that share again.
There is now another way in which you can trade shares and this is by using what is called a contract for difference.
A contract for difference, or CFD, allows you to take advantage of the same price movements, but you do not take ownership of the shares at any point.
A CFD is an agreement between a buyer and a seller
A CFD is an agreement between two parties, one of which is a buyer and the other a seller – one party is usually the broker or a CFD provider.
If a person buys a CFD of a share and the price of that share is higher when the trade is closed, the buyer will receive the difference in the price from the seller.
If the price of the share is lower at the time the trade is closed, the buyer has to give the seller the difference in price.
The agreement is based on the price movement only. So if you buy a CFD of a share, the actual transfer of the share does not take place.
The price of the CFD is based on the underlying share
The underlying share is the actual share that the CFD is based on – remember you are not actually taking ownership and therefore trading the share.
When you trade a CFD of a share, the price of the CFD and the share will be the same – they do not trade any differently.
An advantage to trading with CFDs is that you can use leverage.
When conventionally buying shares, you would have to have the amount that you wished to purchase in your account. For example, if a company had shares worth $10 and you wished to purchase 1000 for them, then you would have $10,000 in your account in order to do so.
If the shares then went up by $0.1 per share, then the shares are now worth $10,100 and you have made $100 in profit.
However, you may not have $10,000 in your account to do so.
Using leverage means that you essentially borrow money from the broker in order to trade more shares than you usually would with your account.
Taking the same example, if you only have $1000 in your account and you still wished to purchase 1000 shares, the broker would effectively lend you $9000 and you purchase the shares with the combined amount of $10,000. This means that if the shares went up by $0.1, then you have still made $100 on this trade.
When you sell the CFDs again, then the money that was financed by the broker is returned and you are left with $1100 in your account.
This is usually known as either a leverage amount of 10:1 or a margin of 10% – you need 10% of the total value to make the trade.
This allows you to gain a higher return on your initial investment than if you traded shares in the conventional method.
Danger using leverage
You must also note, however, that you can also lose just as much as if you had a larger account size. To take the example above, if the share went down by $0.1, then you would have lost $100 and your total capital would have then gone down to $900 – you would have lost 10% of your account.
In order to ensure that a few losing trades do not wipe out your account, you should only ever risk a maximum of 2% of your total trading capital on any single trade.
Costs of trading
For any trade, whether you are trading shares in the conventional way or are trading with CFDs, you need to pay your broker or provider a fee when you open and close your position.
Spreads and commission
Most CFD brokers will charge a spread or a commission of each side of the trade. That means that there will be a charge for both opening and closing the position.
Overnight financing fees
When trading with CFDs, you are liable to pay a financing fee for any long position that you hold overnight. This is usually based on the interbank or LIBOR lending rate, but in some cases it can simply be set by the broker.
If you are short, you are usually credited the lending rate fee, unless the lending rate is extremely low.
CFDs pay dividends
When trading CFDs of shares, you are entitled to dividend payments, as long as you hold the CFD the day before the ex-dividend date, that is the day before which you must own the stock/CFD so that you qualify for receiving the payment. You can find the date on the investor relations webpage of the company whose stock you trade.
To receive a dividend payment, you must hold a long position. You will receive a payment of whatever the dividend is for that company for every share you have. For example, if you owned shares in a company that pays a quarterly dividend of $0.10 per share, you would be credited $0.10 for every share you held.
The process of receiving payments for dividends is usually more straight forward than owning the actual share. When owning a share, the dividend payment may be a few weeks after the ex-dividend date, whereas you usually receive payment the next working day for a CFD.
You are liable for the dividend payment for short positions
You should be aware that holding a short position will make you liable for the dividend payment. If you short sell a CFD of a company's share that pays a dividend, you would be charged the dividend payment for each share that you own.
Even though you are entitled to dividends, you do not have all the same rights as an actual owner. For example, someone who owns shares in a company may be entitled to go to shareholder meetings or have voting rights – owning a CFD does not entitle you to this.
Trading shares vs CFDs
Whether you decide to trade using CFDs or trading the underlying share is down to the preference of the trader – both have advantages. For example, if you would like to hold a position for a significant period of time, then you may wish to buy the actual shares instead of trading with a CFD, because there are no financing costs involved.
It is easier to be able to short sell CFDs than holding the actual shares, because the agreement is usually between you and the broker. When shorting actual shares, an entity would have to lend you the shares to be sold in order to buy them back at a lower price.
Regulation also, from time-to-time, prohibits the short selling of shares, depending on the regulator. Sort selling on CFDs very rarely comes under such restriction.
However, when using CFDs you are able to take advantage of increased return on investment because you can make use of leverage.
In this lesson you have learned that:
- a contract for difference is a agreement between two parties based on the price movement of a share – one party will pay the other party the difference in price.
- a CFD is based on an underlying asset. The price movements are the same.
- there are costs to CFD trading in the form of spreads and commissions.
- if you buy a CFD and hold it overnight, you will usually be charged a overnight financing fee based on the overnight interest rate. If you short sell a CFD then you will usually be credited an overnight interest rate.
- an advantage to trading a CFD is the use of leverage – trading the a higher volume of shares as if you had a larger trading capital.
- CFDs entitle you to dividend payments, but will not entitle you to attend share holders meetings or voting rights.
- if you are holding a short position, then you will actually be charged the dividend rate.
- there are other advantages to trading with CFDs, such as easier access to trade many different shares, speed of execution and they are generally cheaper.