Forex vs. CFD
The brokerage industry is characterized by such a stiff competition that Forex brokers are trying to do everything to attract new customers. But only attracting new customers is not the way to survive in this business. Retaining the current traders is key for a Forex brokerage house. However, this is not an easy task as active trades are difficult to find.
Nevertheless, conditions are still in favor of more and more people to come and join the Forex market. This is because people in all corners of the world have access to the Internet and the number is increasing by the day. A Forex broker needs to split the efforts in two directions: on one hand, it needs to attract new clients, and on another, it needs to keep the active ones’ trading. This is a difficult task to be done. As a business that runs pretty much the same for every brokerage house, the Forex industry offers little chances for brokers to differentiate from one another. If you go and check a list of brokers and their offering, you’ll find out that they are pretty much similar. This is not good for any business as customers are not loyal if there is a similar offer just around the corner. To avoid that, Forex brokers are desperately trying to offer something new every time.
What is CFD?
One way to differentiate a Forex business from another one is to try to keep up with technological changes. This is a field that changes by the day, as more and more things are being developed, and therefore a whole department is needed for this task. Another way is to offer other financial products that can be traded on the same trading account. Such a product is a CFD (Contract for Difference). A CFD can be traded on other products other than the Forex currency pairs. Such products are individual stock companies. As the name suggests, a CFD is a financial product based on the difference between the entry and the exit price. If this difference is positive by the time the trade is closed, a profit is being made. If not, the trading account takes a loss. The trading principle is the same as when trading a currency pair, only that the underlying financial product is different.
Advantages of Trading CFD’s
There are many advantages and incentives to trade the CFD market. The most important one of them all is the fact that the CFD market gives access to a whole new world of opportunities, other than the Forex market. And everything can be done on the same trading account! There’s no need to open a different trading account, as the CFD products are simply being offered for trading in the same account. If the account is opened with a broker that has the MetaTrader platform on its offering, the thing to do is to go to the tab that shows all the currency pairs that are being offered and then simply right-click on any pair. Next, select the “Show all” tab. The result will be that all financial products offered by that Forex broker, CFD’s included, will be listed. This way, the entire offering can be seen. In general, a CFD is based on a company’s stock price. This gives access to the stock market, a market that otherwise cannot be traded with a regular Forex account.
To trade the stock market, a trader needs to open a trading account designed especially for this. This is both time consuming and costly, in the sense that resources are divided. Plus, the same information needed to trade the Forex market can be used for trading CFD’s. That is fundamental information. To give you an example, imagine the Federal Reserve of the United States is raising the interest rates for the federal funds. Such a move is beneficial for the financial sector and banks will be the first ones to see profitability increasing. Therefore, buying a CFD on a bank stock price is the way to go. If indeed, the price of the stock is moving to the upside, the CFD will return a profit, based on the difference between the buying price and the selling price. Of course, trading the stock market is not that straightforward, as other things come and influence the way stocks are moving. Things like earnings calendar, dividend dates, mergers and acquisitions, etc., are all influencing the price of any given stock, and this has nothing to do with the Forex market. However, having access to an entirely new market other than Forex, allows traders to diversify their strategies and portfolios. This is the first step in a proper money management strategy designed to keep the value of a portfolio on the rise.
Disadvantages of Trading CFD’s
The biggest disadvantage when trading a CFD is the margin needed for a trade. This is, by far, much bigger than the margin locked for any Forex trade. Brokers are enjoying this very much as the lower the margin level in a trading account, the more business for them means. Let me explain this in a few words! When opening a trade in a trading account, the margin for that trade is blocked. The more trades are open, or the bigger the volume, the lower the free margin level will be. If positions are going against the trader, the available margin will become smaller and smaller and the trader faces two choices: either will add more funds to the trading account (hence, in the future, will trade some more, so the Forex broker will benefit) or will close the current positions (closing the positions to free margin in the trading account means the Forex broker will benefit as new positions will be opened and commissions and fees will keep pouring in). Therefore, trading CFD’s is costly for the Forex trader, but represents a good business opportunity for the Forex broker. To put it bluntly, for the broker, it is a win-win situation. Besides the margin thing, a CFD is a product that is riskier than trading a currency pair. This is a curious statement to be made about the Forex market, a market considered to be extremely risky. Nevertheless, CFD’s are riskier. These products are moving based on the factors that influence the Forex market, plus some more, like dividend dates, earnings calendar, etc. Moreover, diversifying too much in a trading account has the effect of splitting the attention and focus on too many directions. This can result in the trading account to incur losses as the focus is split. To sum up, trading Forex and CFD’s is similar, but the factors that move the two markets are not the same. Being able to combine the benefits of both markets is something that successful traders do.
Recommended Further Readings
- Forex Trading – Explaining the Concept
– What is forex trading, generalities about trading the currency market.
- Why Trading Forex?
– Advantages and disadvantages of trading the currency market, what are trader’s expectations and what is a realistic approach to follow
- What is a Forex Broker and Types of Brokerage houses
– Explaining what a Forex broker is and does, how the business should be organized, and how many types of Forex brokers exist.
- Financial Products to Trade
– Different categories of financial products that a Forex Broker is offering for the retail clients, starting with the classical currency pairs, and continuing with commodities, CFD’s, indexes, etc.
- Forex Trading Sessions and Their Importance
– Explaining the differences between the three Forex trading sessions, what are their importance, ranking, etc.
- Forex Brokers Types – ECN or STP?
– What is ECN, STP, how d- brokers deal with client’s orders, advantages, and disadvantages of the tw- types.
- Forex Trading – Explaining the Concept
Other Educational Materials
- Risk and Return in Retail Forex. Karbalaee, A. (2012).
- “Locational price spreads and the pricing of contracts for difference: evidence from the Nordic market.” Marckhoff, Jan, and Jens Wimschulte. Energy Economics 31, no. 2 (2009): 257-268.