With several similarities to forex trading, it’s no surprise that CFD trading has garnered a lot of interest among our readers. Of course, there are some key differences that you should know about as well. In case you’re wondering what CFD stands for, better check out my newbie-friendly intro to CFD trading first.
Range of Markets
CFD trading spans a larger set of financial markets, as these contracts can involve various commodities or equity indices of several countries. Some brokers even offer CFDs on stocks traded in different exchanges, opening a very wide realm of trade opportunities!
Compared to spot forex trading which is limited to the currency market, CFD trading does seem to offer a much broader array of trading choices. Bear in mind though that some assets are often limited to their local denomination (ex: S&P 500 against USD or shares of Royal Dutch Petroleum against GBP).
Factors that affect price movement in CFD trading depends on the markets in which the asset is part of. For instance, crude oil CFD prices are mostly driven by supply and demand or by seasonality. Prices of equity CFDs can be determined by business factors or company-specific events, such as earnings or acquisitions.
Meanwhile, price movements in the spot forex market are mostly influenced by fundamental factors, such as economic growth and monetary policy expectations. Risk sentiment also plays a role in currency price action, along with geopolitical tension and to an extent, environmental factors.
CFD and forex trades are generally executed in the same manner in an OTC market under a decentralized exchange. Both types of trading don’t involve the physical transfer of the assets, as profit or loss are calculated based on the opening and closing prices. Because of these similarities, several brokers actually offer platforms that cater to both CFD and spot forex trading.
Both spot forex trades and CFD trades make use of margin, with the former generally quoted through a leverage ratio (ex: 1:100 or 1:10) and the latter stated as a fixed percentage (ex: 1% or 5% margin factor).
If you need a quick review on what these terms are all about, it’s time for you to head back to our School of Pipsology lesson on margin and leverage. In a nutshell though, both types of trading allow you to control a larger amount of money with the margin as your “good faith deposit” to the broker. As always, remember that leverage can be a double-edged sword!
With forex trading, transaction costs are generally based on the bid-ask spread quoted by the broker. In CFD trading, transaction costs can involve commissions, which vary depending on the underlying asset. The costs of trading equity CFDs are still generally lower compared to purchasing actual shares while index-based CFDs don’t usually carry commission costs.
CFD positions held open overnight can also incur overnight financing costs, which consists of a daily charge based on the size of the contract and often linked to LIBOR or central bank benchmark rates. With that, trades kept open for much longer are subject to increasing interest charges, which can wind up eating a huge chunk of your trade returns. On the other hand, financing costs on short CFD positions are typically received by the trader.
Brokers offering commodity CFDs usually have the futures market as the basis for their contract pricing, which means that there may be expiry dates and settlement costs as well. The broker can arrange an automatic rollover when the settlement date of the associated futures contract is reached or deduct a cash settlement fee from the CFD position, which could also significantly reduce profits if you keep the trade open for a long time.
If you are considering trying your hand in CFD trading, it is recommended that you work with markets that you are more or less familiar with. As with forex trading, you might be better off playing with a demo account first before risking real money in a relatively unfamiliar territory.