A relatively new trading vehicle that has become extremely popular among investors and traders is the contract for difference or CFD.
A CFD differs from many investment products in that it is a contract between a buyer and seller to settle the difference in cash based on the subsequent performance of an underlying asset, derivative or exchange rate over a pre-specified time frame.
CFDs can be bought or sold as either a hedge or as part of a long or short trading strategy, depending on the traderís or investorís preference. CFDs have a specific maturity date and can be incorporated into an overall forex trading strategy.
What is a CFD?
Basically, a CFD is a contract between two parties, a buyer and a seller, which stipulates that the seller will pay to the buyer the cash difference between the present value of an asset and the value of said asset at the time the contract matures, if the difference is positive.
Conversely, if there is a negative difference instead, then the buyer of the CFD pays the seller the difference in cash.
Basically, a CFD is a type of financial derivative that can be traded on a wide variety of assets including: commodities, equities, indexes, industry sectors and foreign exchange currency pairs.
While CFDs can now be traded on the Sydney Futures Exchange as exchange traded CFDs, most CFDs are traded in the over the counter market by dealers and market makers. Residents of the United States cannot trade CFDs.
Leverage and Lot Size Differences for Forex CFDs
Perhaps the most important difference between trading forex and trading a CFD on a forex currency pair consists of the amount of leverage available. A forex trade done through an online forex broker is typically leveraged as a ratio to the margin required to hold it, for example at 100:1. In contrast, a CFD is generally margined as a fixed percentage of the transactionís notional value.
Also, online forex trades are usually done in lots of 5,000 or 10,000 base currency units, while a single CFD is generally for 5,000 units of the base currency, depending on the broker or market maker.
To compare a CFD trade with a normal online forex trade, a regular forex trade of 5,000 units of a currency pair would be subject to the bid/offer spread as a transaction cost and would have a leverage ratio of 100:1. An equivalent CFD trade would be to purchase or sell 1 CFD at a cost of one percent of the notional value of the position.
Stop Losses and Margin Requirements for Forex CFDs
One advantage of taking on the forex CFD trade versus a conventional forex position is that many CFD dealers offer their customers guaranteed stop losses, which are rarely offered by an online forex broker.
Furthermore, because forex trades can be adjusted for leverage, the overall amount of margin required for a forex trade could be substantially lower than for a CFD. This depends on the amount of leverage for the forex trade, for example a leverage ratio of 500:1 would make the margin costs significantly lower for the forex trade.
CFDs also offer forex traders an alternative hedging vehicle, which can be used to offset positions already taken in the forex market. As such and in their own right as a directional trading vehicle, forex CFDs can be readily incorporated into an overall forex trading strategy.