Speculating with Forex CFDs - ORBEX · CFDs on the other hand, are margined as either a fixed...

SPECULATING WITH FOREX CFDS

CONTENTS

01

02

03

04

05

07

09

10

Disclaimer

Introduction

How to Start Trading CFDs

CFD Basics

How to Trade Forex with CFDs

CFD Initial and Variation Margin

Advantages and Disadvantages of Using CFDs

Disadvantages of CFDs


01

DISCLAIMER

RISK DISCLOSURE

The information contained in this eBook is provided for information purposes only. The information is not intended to be and does not constitute financial advice, is general in nature and is not specific to you. Before using the information contained in this eBook to make an investment decision, you should seek the advice of a qualified and registered securities professional and undertake your own due diligence. None of the information contained in this eBook is intended as investment advice, as an offer or solicitation of an offer to buy or sell or as a recommendation, endorsement or sponsorship of any security. Orbex is not responsible for any investment decision made by you. You are responsible for your own investment research and investment decisions.

There is a substantial amount of risk in trading currencies and CFDs and the possibility exists that you can lose all, most or a portion of your capital. Orbex does not, cannot and will not assess or guarantee the suitability or profitability of any particular investment or the potential value of any investment or informational source. The securities mentioned in this eBook may not be suitable for all investors. The information provided by Orbex, including but not limited to its opinion and analysis, is based on financial models believed to be reliable but it is not guaranteed, represented or warranted to be accurate or complete. Your use of any information from this eBook or Orbex site is at your own risk and without recourse against Orbex, its owners, directors, officers, employees or content providers.


02

INTRODUCTION

A CFD or Contract for Difference is a financial derivative that does not expire. It consists of a contract between a CFD provider and a speculative trader to exchange the difference between the price the contract is initially dealt at and the price that the contract is eventually closed out at.

If the trader’s view is correct and the market moves in their favor after a CFD contract is opened, then the difference will be a positive one that they will receive from the CFD provider. On the other hand, if the market moves against them, then they will have to pay out the negative difference to the CFD provider.

Forex traders can use CFDs to speculate on exchange rate movements in a variety of currency pairs, although most CFD providers offer CFDs in only the major currency pairs and crosses. For example, these might include the EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD, AUD/USD, NZD/USD and EUR/JPY currency pairs.

Dealing spreads on CFDs depend on the CFD provider, but they can be as tight as one pip for currency pairs like EUR/USD, although one and a half to three pip spreads are more typical. This is similar to the best dealing spreads offered by online forex brokers.

In locations that require the payment of capital gains tax, CFD trading profits could be taxable, while CFD losses may be tax-deductible.


03

HOW TO START TRADING CFDS

In order to begin trading CFDs, you will need to identify a suitable and reputable CFD provider. These companies typically now operate with online interfaces known as trading platforms where you can open and close CFD transactions via your computer if it connected to the Internet. Some online forex brokers are also CFD providers that offer CFD trading in addition to regular forex transactions on their trading platforms. Quite a few CFD providers even offer access to the Metatrader 4 trading platform which gives the trader access to forex, commodity futures and other financial instrument CFDs.

Opening a CFD account with an online CFD provider typically requires a nominal initial investment. In the UK, some CFD providers like City Index offer to open an account for just £100, while other CFD providers might require higher minimum deposits.

Due to recent restrictions on over the counter transactions, the U.S. Securities and Exchange Commission has banned U.S. citizens and residents from trading CFDs. Some CFD websites are therefore unavailable for viewing by people located in the United States.


04

CFD BASICS

One of the chief advantages of trading CFDs is the high leverage available. The maximum some online forex brokers will allow is 500:1 leverage on forex trades for non-U.S. residents, and that is equivalent to the very low 0.2% margin requirement some CFD providers offer for forex CFDs.

As a result, CFD trading allows the trader to take a much larger position than they could with a direct purchase since the high amount of leverage winds up costing them only a fraction of what a direct purchase would entail. Under normal circumstances, a direct purchase would cost the trader either the full amount of the transaction, 50 percent in the case of stocks, or 20 percent in the case of futures contract.

To establish an equivalent forex position by using a CFD, a trader would require only 0.2 up to 1.0 percent of the value of the CFD.

The effect of this high amount of leverage on a position means that a larger position can be taken with a smaller amount of initial capital. Of course, while profits may be magnified due to leverage, so are losses.

Because CFDs can be sold short as well as purchased, forex traders can use CFDs to hedge existing positions or assets. For example, if a forex trader has an existing position in a currency pair with a forex broker, they could take an opposite position in a CFD to establish a hedged position. If the market goes against the initial position, the gains on the CFD position would offset the losses.


Trading forex with CFDs is much the same as trading currencies in the spot market with some key differences. The main difference consists in the amount of leverage on any given position. A forex trade has a leverage ratio determined by the trader, i.e. 50:1, 100:1, 200:1, 500:1, etc. CFDs on the other hand, are margined as either a fixed percentage of the trade’s notional value — typically 0.2 to 0.5 percent — or as a margin factor, for example a 500X stake, which means 50 times the money deposited as margin. Also, forex quantities are traded in lots such as 10,000 or 1,000,000, while CFD contracts are traded in specific amounts chosen by the trader opening them.

A quote for a forex CFD is made with a bid and an offer, much like a forex spot trade. The CFD transaction is margined based on the notional value of the transaction and the fixed percent quoted by the CFD provider, while the forex trade is margined at a specific leverage ratio. Leverage, or holding a large position with a smaller amount of money placed on deposit as security, is one of the reasons that CFDs have become such a popular trading vehicle.

As an example, consider a purchase of €100,000 in a EUR/GBP CFD at an exchange rate of 0.8550.

If EUR/GBP has a typical tier 1 margin rate of 0.20 percent at the CFD provider, this means that only 0.20 percent of the total position’s nominal value is required to establish and hold the position. Therefore, for this example, the margin required on that CFD position to hold it would be ((0.20/100) X €100,000) = €200.00.

Make note that if the exchange rate moves against the position, the resulting loss could significantly exceed the initial margin requirement of €171.00. Also, if the position is held past 5PM New York time, then the position is debited or credited depending on whether the interest rate on the long currency is higher (credited) or lower (debited) than the short currency.

In addition, the CFD provider might require additional maintenance margin if the exchange rate has moved against the position.

HOW TO TRADE FOREX WITH CFDS

05


If the exchange rate then moves favorably to 0.8625 the trader makes the decision to liquidate the CFD at that price. The rate has moved up +75 pips. The profit on the trade is (€100,000 X (0.8625-0.8550)) = £750.00.

If conversely, the EUR/GBP rate declines to 0.8495 then a loss of £550.00 would be incurred: ((€100,000 X (0.8495-0.8550)) = -£550.00 In a straight forex trade at a leverage ratio of 100:1, the above transaction would have required 100,000/100 or €1,000.00 in margin to hold. At a leverage ratio of 400:1, the trade would cost €250.00. The CFD transaction at a 0.20 percent margin is significantly more cost effective than a forex spot trade even at a rather high leverage ratio of 400:1, because it corresponds to a 500:1 leverage ratio that only requires €200 to hold.

HOW TO TRADE FOREX WITH CFDS


06

07

While CFDs have no expiration date, any CFD positions held after 5PM EST are rolled over. This means that the position is “marked to market”, or any profit or loss on the position is reflected in the account, with losses being debited and gains credited, in addition to any financing charges based on the interest rate differential between the currencies involved. The position is then carried forward to the next day. Because CFDs are traded on margin, the trader must keep a certain amount of money — called the minimum margin — in the account as long as positions remain open. One desirable feature of a CFD provider is that each trade’s profit and loss, along with the margin requirement, should be updated constantly in real time and shown to the trader on their CFD trading platform.

If the money on deposit with the CFD provider falls below the required minimum margin level, the trader could receive a margin call. If the margin requirements fail to be met after a margin call, then the CFD provider could liquidate the trader’s position. CFD traders are required to maintain a certain amount of margin in their account for their positions as defined by the CFD provider or market maker. This maintenance margin ranges from 0.2% to 1.0% for forex trades to as much as 30% for some high risk CFDs on volatile stocks. While leveraged positions can be extremely profitable if the trader’s view is correction, if the market goes against the position, significant losses

can be incurred. Trading CFDs on volatile markets can be especially risky, exposing the trader to unexpected losses and margin calls during violent moves, which could lead to the erosion of a significant portion or even all of their trading account. CFD traders must maintain two types of margin:

CFD INITIAL AND VARIATION MARGIN


Initial Margin - generally between 3% and 30% for stocks and 0.2% - 1% for commodities, indexes and foreign exchange.

Variation Margin – the amount requested by the broker to hold a position after it is “marked to market”.

08

Initial margin for CFDs on assets which display significant volatility can be quite high and can change with market conditions. For example, after the 9-11 attacks, initial CFD margins on stocks were raised considerably due to the sharp increase in volatility in world stock markets.

For forex CFDs, the initial margin requirements tend to be significantly lower for liquid, heavily traded currency pairs in calmer markets than for thinly traded, illiquid assets in volatile markets.

Variation margin, also known as maintenance margin, is applied to positions that have moved against the trader. For example, if a CFD trader bought 100,000 of a EUR/USD CFD at 1.2550 and the exchange rate closed at 1.2490 at 5PM EST, the broker would then require an additional deposit to the account of $600.00 to cover the loss on the trade if that amount was not already available in the account.

Conversely if the trader was short the CFD at the same price, then their account would be credited with a positive mark to market value of $600.00 to reflect their profit.

Therefore, variation margin can either be beneficial or detrimental to a CFD trader’s cash balance. Nevertheless, initial margin is always deducted from the traders account when a position is established and is replaced in the account once the trade is liquidated.

CFD INITIAL AND VARIATION MARGIN


Some of the notable advantages of trading CFDs include:

Liquidity – CFD rates mirror the forex market to a certain degree providing the liquidity of the forex market, as well as the liquidity provided by the CFD provider.

Leverage – CFDs require only a small deposit, typically 0.2% to 1% for forex CFDs, which means a more efficient use of capital. Low transaction costs – typically forex CFDs trade with the same market dealing spreads as the forex spot market, which generally run between 1 and 5 pips.

Ease of execution – with a reliable CFD provider, entering and exiting the market is as easy as clicking a mouse. No fixed contract size – a CFD provider can customize the size of any forex position to the trader’s requirements. No expiration date – CFDs do not have a fixed expiry. Stop and stop loss orders – CFD providers give traders the opportunity to enter stop orders with ease.

Guaranteed stop loss – many CFD providers give clients a guaranteed stop loss, which means that when the contract is purchased, the CFD provider guarantees that the trader will lose no more than a set amount on the trade.

Daily statements and online account reporting – Most CFD providers offer sophisticated trading platforms that keep track of positions in real time, as well as providing daily account statements to clients.

Interest paid – if a position is held in a currency pair where the short currency’s interest rate is lower than the long currency, then interest is paid to the trader.

09

ADVANTAGES AND DISADVANTAGES OF USING CFDS


Some of the notable disadvantages of trading CFDs include:

Re-quotes - In volatile markets, CFDs tend to be re-quoted often.

Leverage – as much of a disadvantage as an advantage, while potential profits are magnified, so are losses.

Losses limited by the funds in your account – holding a CFD in a fast market situation can be disastrous if the losing trade is held without a stop loss. Margin calls will make the trader deposit more money or liquidate positions.

Over trading risk — A combination of easy access and low capital requirements can lead to over trading CFDs, so if you have a gambling problem, you might want to refrain.

Interest charged – if a position is held in a currency pair where the short currency’s interest rate is higher than the long currency, then interest is charged similar to a forex rollover fee.

Marked to market – CFDs typically have a collateral deposit requirement, which means that any deficiency in funds for an established position must be made up for in the account or the account is liquidated.

10

DISADVANTAGES OF CFDS


A FOREX MARKET OVERVIEW

LICENSES & REGULATIONS

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Speculating with Forex CFDs - ORBEX · CFDs on the other hand, are margined as either a fixed...

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