Difference between Forex and CFD
Trading forex is very interesting to many investors and day traders, and the brokers offering forex trading come in many different types. Mainly you see MM (Market Maker) type brokers, STP (Straight through Processing) type brokers, and ECN (Electronic Communications Network) type brokers. Today things are more complicated and most brokers actually use hybrid models, which combine all three types, in one account. An ECN forex broker however is a true ECN, if and only if their spreads are variable. Brokers offering fixed spreads cannot possibly be ECN type.
CFD forex brokers are a kind of market maker broker, but not exactly that. Even the term market maker is a very inclusive one, and doesn’t quite describe accurately the nature of CFDs. But you can think of CFD brokers as a very advanced type of market makers, which has little to do with classic market makers. CFD brokers offer a substitute for the real markets, which is perfect in many ways, and in some cases better than the real markets themselves. This is because the CFD liquidity pool filters out most of the adverse volatility of the markets, making easier and realistic for the CFD trader to trade fast and accurately. The catch is that this liquidity is limited to a trading size of around $100 per pip. This limit also applies to all MM type forex brokers.
A CFD broker usually offers many more markets to trade than just forex, you usually get forex, commodities and stocks, all in one account, whereas with a spot forex broker you are offered currencies and possibly only two or three commodities, usually gold, silver and crude oil.
Some forex traders also trade commodities, and in some cases they also trade commodity related stocks, so in that regard a CFD account will be better.
Dealing costs are similar in both CFD and spot forex accounts, because they are leveraged products, overnight interest rates apply, and the appropriate amount of money is charged or credited on the open trade held overnight. In terms of taxation, spot forex trading is actually tax free in most countries, whereas CFDs are subject to taxation law, as if they were stocks or other taxable assets, but tax only applies to profits made, not to transactions themselves.
Gaining Market Insight through the ECN Spreads
Even though you may never trade through an ECN broker, it’s a good idea to have access to an ECN account, a real ECN account that is, so as to monitor the variable spreads. When it comes to fast day trading, by watching both price action at critical pivot levels, and the ECN spreads at the same time, you will be able to get a feel on market volatility and whether or not a price breakout will hold or will turn out to be a false one. The more volatile a market is, the less liquid it is, and if liquidity doesn’t return back to normal, it means that price is becoming unstable, or at least you cannot trust it as much. And volatility is what makes ECN spreads widen! It’s a very fast, very real time indicator, but it tells all the truth.
Wise forex traders establish acceptable volatility baselines for every currency pair they trade, and if ECN spreads are a little wide but come back to normal, that is okay, a breakout may be solid. But when a breakout occurs and ECN spreads are way too wide, or stay wide for too long, it tells traders to be suspicious of the breakout.
This strategy can be implemented on a good MM or CFD forex account, where the trades are carried out, while watching the ECN spreads through an ECN account where you don’t trade, even on a realistic Demo account, it will still work.
Carry Trade Strategy
The Carry Trade strategy is when traders attempt to profit out of the interest rate differentials on various currency pairs, and not from directional movements. But in recent years, wise traders have developed strategies where both objectives can be pursued. It’s actually possible to profit from interest rate differentials and from partial directional movement, all at the same time. This is implemented as a single strategy, on various CFD and ECN forex accounts.
Though no information is available, it is logical to think that these traders probably hedge directional risk, through CFD trades, on a correlated currency pair, which has different interest rates. Such strategies are complicated and require exact calculations in order to work. But they are possible. In any case, the idea is to exploit the different interest rates of currencies, but also the different rates that brokers offer on them. All brokers, both CFD and spot forex, offer different rates each.
The Carry Trade strategy requires a lot of money, at least $30,000, high leverage accounts, good planning and calculations, but it can generate $300 per day. Very few traders can get it right, but some do.
Trading One Commodity and One Currency Pair
Commodity traders do both commodity and forex trading, such as gold traders for example who also trade correlated currency pairs, such as AUDUSD, and for long periods of time the market actually allows you to trade one of these, while hedging excessive risk with an opposite trade on the other market. Correlation is not exact, neither does it work all the time, but commodity traders know a lot, in the case of gold they know how much gold is expected to move because of supply and demand, and how much it can move because of fluctuation in the US dollar, so they can trade specific US dollar risk, through a separate, third CFD contract.
Gold is one of those interesting markets, where you can actually develop trading ideas based on the daily price movement alone, by breaking down the daily movement into a supply and demand component, and into US dollar impact component. What tends to happen is that if for example gold has moved $30 up for the week, and $15 of that was due to supply and demand, and $15 was that because of the US dollar dropping, then in the coming days the gold market will actually be set to decline by $15, even if the US dollar remains unchanged for a week. It’s as if the supply and demand action eventually prevails over sudden US dollar movements.
This phenomenon is not well understood, but it does happen, the supply and demand forces prevail, for at least several days, over sudden movements in the US dollar, and together with the latest supply and demand, and US dollar movements makes it possible to predict many day to day moves in the gold market. Moves that can be traded with CFDs, to the last penny.
They say that hedging is a fools’ game, but not really, in cases such as in gold and crude oil, traders can breakdown the forces that make these markets move, and trade one CFD on the commodity, and one more CFD on the US dollar index, or even a CFD on EURUSD of such size, so as to match the US dollar index.
So in the case of gold, the objective on the mentioned example is to trade the long side of gold, with one CFD, and then use one more CFD to hedge the risk posed by the US dollar, which means it has to be a long CFD trade on the US dollar. If the US dollar stays flat, the hedging trade stays flat. If the US dollar rises by X% it will cause a loss of X% on the price of gold. But all that loss will be offset by an X% gain on our long CFD US dollar trade. So we have locked the US dollar risk, away from our gold trade. And if we are right on gold’s supply and demand we stand to profit right away. But even when wrong, huge, sudden movements of the US dollar, will be at least somehow offset by the supply and demand component, a very easy trade to detect and make. So I guess hedging is not always a fool’s game like many would try to convince you. And CFDs make it possible to do both commodity and forex trading all in one account, how amazing and convenient is that.
You can think of supply and demand, and the US dollar, like the egg and chicken dilemma, where one can create the other. When the US dollar rises, it makes a commodity priced in US dollars become cheaper, hence the commodity drops in price, and stays so for many hours, but now the lower price creates new, fresh demand among bargain hunters who already have US dollars, to buy more of that commodity exactly because it is cheaper.
The Effects of Currency Rates
The impact of various exchange rates is real across many markets, and all CFD markets are quoted in the same currency that that market is traded in. So CFD traders can enhance their trading by taking currency movements into account, and trading them accordingly. You can trade them all in one CFD account, or you can use a separate forex account to do these forex trades. In most cases, there’s no substantial difference whether you trade forex through CFDs or through a classic forex broker, such as an ECN broker.
The forex market makes all kinds of trading more interesting, and it is relevant even to real estate investing, because you can take out mortgages in foreign currencies to buy properties in third countries. The idea is to maintain the mortgage debt in currencies that are depreciating over time, against the currency your income is in. Again, you can hedge various market and interest rate risks, through both CFDs and ECN brokers, and even through simpler MM brokers.
Fast Day Trading
In fast day trading and scalping, you can use either CFD or ECN brokers, the simpler MM brokers will still work but not as good as these two types. In terms of slippage and requotes CFD brokers are slightly better, but only when you use their Limit orders, not Market orders, to open new trades. Some traders can trade like this, some others cannot trade this fast.
ECN brokers will be better for larger size trading, whereas CFD brokers will provide the best liquidity for medium to smaller size trading. So for trading with under $50 per pip, CFDs are definitely good, may be better than ECN, whereas as you go above $50 and close to $100 ECN will be better. In any case where fast day trading is carried out, traders can use ECN spreads as indicators, regardless what type of broker they trade through.
In the case of placing overnight stops, and you want them to be guaranteed, a CFD broker will actually be better, through the use of a Limit order, where you basically close your losing trade, and or open one in the opposite direction, this works better with CFDs than with ECNs especially when market conditions are rough and too volatile.
More Ideas Relating to CFDs
All in all both CFD and ECN brokers can cover your trading needs, and even MM and STP brokers to quite an extent. The differences become apparent only during extreme market conditions, but very few traders use strategies where such differences have to be looked into. The main thing to think about, is whether you want to trade stocks and commodities and forex, all in one account, and whether tax legislation in your country favors classic forex brokers over CFD brokers. And in such cases you may want to use both types of brokers, each for different strategy.
Finally, there’s no real obligation to pay tax on your winnings, in any country, since it may be possible to withdraw your funds from your CFD trading account, through the markets themselves, and through a separate type of account, such as a classic forex account which is not subject to taxation. In such cases, you simply have to open one trade in your CFD account, and an opposite trade in your forex account, wait for the money to shift over to your forex account, and then close both trades. Thereby getting all the benefits of CFDs, without having to pay 30% capital gains tax. That is also something to think about.