CFDs (Contracts for Difference) have emerged as one of the most innovative trading instruments in recent years and their popularity is increasing. The growing importance of CFDs is proving a game changer. Thus, it is no surprise that investor interest in the various possibilities that CFDs offer vis-à-vis other trading options is increasing.
Before you read on, you may need to have CFDs explained in order to understand what trading is all about. Simply, CFDs are instruments that allow you to trade in financial products and markets, including equity, commodity, and foreign exchange (forex). One of the questions investors often ask is whether CFD trading is more profitable than spot forex trading. For investors who are looking for a little more excitement outside the spot forex markets, a comparison between CFD trading and spot forex trading would be a significant tool that would assist them in making well-informed investment decisions.
What are the similarities between CFDs and spot forex trading?
To understand the similarities and difference between CFD trading and spot forex trading and evaluate the advantages and disadvantages of each of these instruments, you will need to first know what a spot market is. A spot market is one where financial instruments such as commodities, securities, and forex are bought or sold and then delivered immediately. A spot market is also called a cash market or physical market. Contracts bought and sold on a cash market are immediately effective. The difference between the spot market and the futures market is that, in the spot market, money is exchanged immediately for the purchase and sale of the asset.
You have seen that CFDs are contracts between an investor and a broker or investment bank, in which both of the parties agree to pay the difference between the entry and exit price of an underlying asset. Through the CFDs, investors can speculate on the foreign exchange markets and on other assets such as metals, oil, and market factors such as indices.
Both CFDs and forex offer margins, the only difference being that margins on CFDs are generally expressed as a percentage, whereas margins in forex trading are generally quoted through a leverage ratio. Another similarity between CFDs and forex is that their trading costs are at least partially based on spread, the difference between entry and exit points.
The factors influencing price movement in CFD trading depend on the markets of which the underlying asset is a part. For example, prices of crude oil CFDs would be influenced by demand-supply dynamics and seasonality. Company-specific events such as acquisitions and quarterly earnings reviews influence the prices of equity CFDs. These factors are well researched and analyzed and, by and large, are along expected lines barring a few negative surprises. Factors that influence price movements in spot forex trading are fundamental ones such as economic growth and monetary policy expectations, which, more or less, are anticipated. Geopolitical risks can also often play spoilsport. Thus, volatility caused by the influencing factors is largely similar in both the cases.
Which is better, spot forex trading or CFD?
Both spot forex trading and CFDs have their own set of advantages. Trading in CFDs, for instance, covers a larger set of financial markets whereas spot forex trading is limited to the currency market.
Thus, when it comes to choosing between spot forex trade and a forex CFD, an investor should look at how the trade happens to understand the flexibility or comfort each of these instruments offers.
In a spot forex trade, an investor buys or sells a forex pair at the current rate, which involves a direct exchange between currencies and is a cash transaction. In case of a forex CFD, the CFD replicates the movement of an asset like it does in case of shares or futures. Thus, the only technical difference is that, in spot forex trading, there is physical exchange of currency at the prevailing rate whereas, in case of a forex CFD, you will be trading at the price given by the provider. More often than not, the prices are not as identical as the underlying assets. So the provider with whom the investor is entering into a contract with is the counter-party as well as the sole market maker.
However, CFDs have an advantage over spot forex deals in that the price at which a forex CFD is entered into becomes the base price and the trader is not concerned with the minimum or maximum value of the currency pair. The only factor that affects the trader is whether the price of the currency is above or below the contracted price. Thus, if an investor is located in the UK, the CFD will be priced in sterling. So, when the sterling depreciates, the CFD of a foreign asset becomes attractive.