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Forex CFDs vs Spot Forex

Forex CFDs versus Forex Spot Trading

Q:Are there any differences between forex spot trading and trading forex on a CFD account?

A: Essentially there are two ways to trade forex: using CFDs or margin forex. Many CFD brokers are promoting themselves to be Forex brokers these days, which they have always offered but is there any edge in using them versus a normal Forex broker who specializes in that field? Trading Forex on a CFD account is similar to trading traditional Forex, ie. you would buy or sell a set value of currency, eg, $10,000 USD.

Spot Forex: A spot forex trade involves either buying or selling a forex pair at a current rate. This involves a direct exchange between to currencies. Such transactions involve cash as opposed to a contracts and interest is not included upon the agreed transaction. Should you wish to keep the position open or rollover you must enter into a swap transaction involving your forex pair.

Forex CFDs: A CFD replicates the movements of an asset like futures or shares. Thus, for instance if it is based on the EURUSD, then the spot EURUSD is the underlying of that specific CFD. CFDs are not traded on common exchanges, as opposed to their underlyings and are exclusively traded over-the-counter.

Rolling Spot Forex is not a regulated investment in the United Kingdom, nor the USA. The USA only has a so-called NFA to charge fees if a market maker offer spot forex and in the United Kingdom, it is in line with BoE’s Non-investment Products code.

Thus, the only superficial technical difference is that when you are trading with a provider on a Forex CFD, you will not be buying the actual currency. You will be trading on the provider’s prices. A problem with CFDs is that they almost never have exactly the same identical prices or the same spreads in their underlyings. Your CFD provider acts as the counter-party and sole market maker in all your trades, so in absence of inhouse hedging mechanisms you can end in a situation where when you win, the provider will lose, whilst when the provider wins, you will lose. CFD providers are sometimes criticised for setting arbitrary spreads or suspending trading in crucial moments. Perhaps more significantly is that forex based CFDs will be based on the cash market but it will be more trusted if the provider tells you that they use CME’s currency futures or Tier 1 Banks’ prices and liquidity for hedging.

Contracts for difference also have Rollover financing: Clients will either receive or pay financing.

-> If a client is LONG and has a higher interest yielding currency it will be credited.
-> If a client is LONG and has a lower interest yielding currency it will be debited.
-> If a client is SHORT and has a higher interest yielding currency it will be debited.
-> If a client is SHORT and has a lower interest yielding currency it will be credited.

An advantage with CFDs is that the price at which a forex CFD is bought becomes the base price. The trader isn’t concerned with the least or the maximum value of the currency pair, instead he is only affected by whether the price of a currency is above or below the contract price. For instance for a CFD holder located in the UK, positions will also be priced in sterling, which makes the CFD of a foreign share or asset more attractive when sterling depreciates.

This is unlike what happens with conventional forex dealing where the gain or loss on a currency trade is denominated in the second currency; so for instance FXADUS measures the value of one Australian Dollar in terms of US Dollars. Thus, if the FXADUS is currently trading at 0.9200, this means 1 Australian Dollar buys 92 USA cents. You could, of course trade the FXUSAD in which case your profits or losses will be in Australian Dollars. Should you trade the FXEUBP, your profits and losses will be in British Pounds.

Taking the case of a forex spot trader who trades the FXUSJY and who starts with an account size of $A30,000. The trader manages to make a profit of 1,500,000 Yen which translates to about $A18,519 if one Aus $ buys 81 Yen (1,500,000/81 = 18,519). Thereby the trader’s account will have two balances; they still retain the 30,000 Australian Dollars, but they also have 1,500,000 Yen. Now, in practice this amounts to a total account balance of $A48,519 (18,519 + 30,000) but currency pairs are in constant fluctuation. The FXADJY being the value of the Australian Dollar against the Japanese Yen; which means that when the FXADJY is trading at 81, then 1,500,000 Yen is worth $18,519 but if the FXADJY were to rise to say 91, then the same 1,500,000 Yen would be worth ‘only’ $16,483 (1,500,000/91). So even though the trader hasn’t placed any trades he has still lost $2036 in the currency fluctuation. A way to mitigate this risk with forex spot trading would be to immediately convert all foreign currency values back to your primary currency as soon as you close a trade.

It is also interesting to note that forex CFDs are also traded on margin (similar to forex spot trading) with leverage possible up to 500:1 in some cases. In any case, the real advantages with CFDs is mainly what you can do with share trades, and the ability to trade multiple global markets from a single brokerage account. Due to the carry costs on the long side of CFD trades which are computed based on the entire position as it rises and falls in value, not just the loaned portion as with a margin loan, a different strategy needs to be employed from other share trading instruments to offset this cost or there is no benefit, and probably a cost, in trading CFDs (although using the leverage to free up capital for other trading instruments has some benefit, but marginal in this case as there are other ways to do this). CFDs are a BRILLIANT instrument if you can get your hands on it as a professional trader, but you have to trade it aggressively and employ all the risk management tools it affords you.

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