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Should You Follow the Market into Index/Commodity CFDs? | Trading Forex

Retail Forex trading has been around now since about the turn of the century, although it really only took off about 7 years ago when high-speed broadband connections became widely available.

Retail Forex brokers began by offering spot Forex, and this is still the mainstay of the business. In spot Forex, the trader buys or sells nominal quantities of one currency in exchange for another currency, seeking to profit from directional moves.

The industry later expanded into offering clients the opportunities to trade in a wider range of assets, such as a range of the more liquid commodities and share indices. The industry is still full of brokers calling themselves “Forex” brokers, but the non-Forex component of their business continues to grow to the point where “Forex broker” is almost becoming a misnomer.

Commodities such as gold and oil, and share indices, as well as individual shares which are offered by some brokers, are typically offered as CFDs (“Contracts for Difference”). Sometimes Forex currency pairs are offered for trading wrapped as CFDs too. This avoids the question of the ownership of the underlying assets and also can provide some tax advantages. In a CFD, the broker and the trader just agree that one will owe the other money to the sum of X units of currency for every point of increase or decrease from the trade entry point. CFDs are just a legal wrapper and shouldn’t be confused with the underlying assets, but they often are as share indices and commodities are typically wrapped as CFDs.

Why are Brokers Offering More Commodities and Equity Indices?

Brokers are in business to make money and the simple answer to the question of why more and more brokers are expanding their offerings is simple: because there is an increasing demand to diversify out of simple Forex, and also because the spreads that can be charged on commodities and equity indices are higher, leading to an easier profit for the broker offering such instruments.

For example, let’s take the cheapest Forex pair to trade, EUR/USD as an example. Competitive Forex brokers typically in normal market conditions charge about 1.2 pips as a total for “round trip” spread and commission. This means that on every trade, once you have opened and closed the trade, you are paying about 1.2 pips to the Forex broker.

At the time of writing, the market price of the EUR/USD currency pair is about 1.1000 i.e. 11,000 pips. This means that the cost of 1.2 pips to trade represents an effective trading fee equal to 0.0001% of the value of the asset. This seems like a very small commission to pay. Compare this to the S&P 500 Index, which generally costs around 0.9 points to trade. The current value of this Index is 2,108 points, so the cost of trading equals about 0.0004% of the value of the asset: so a broker can charge about 4 times the commission for that compared to a currency pair such as the EUR/USD. When you consider that most brokers do not cover their full book on the real market, higher spreads usually means higher profit for them. Commodities, like equity indices, are also generally more expensive to trade than non-exotic Forex pairs.

Why do Clients Want Commodities and Equity Indices?

So if these instruments are more expensive to trade, why are traders so keen to get access to them? It is partly a case of fashion, and human nature seeking novelty as Forex begins to feel a little stale. However there is also a very good practical reason: commodities and equities tend to trend more and exhibit greater volatility than Forex currency pairs, and therefore even with the higher trading costs including overnight swap rates, it is easier to make money trading these instruments than it is trading Forex.

This might be surprising information, but currency fluctuations in value are relatively small. Forex also has a strong propensity to range, i.e. revert to its average price. Compare that with commodities such as oil that can halve or double in value in a matter of two or three months, or equity indices that frequently trend upwards and double, triple or more over multi-year bull markets.

Commodities and Equity Indices Show Stronger Momentum

In order to try to prove that commodities and equity indices tend to show stronger directional moves than Forex, I looked at the price changes of 38 Forex currency pairs, 4 commodities, and 12 equity indices, measuring the price changes of each over the previous 3 months and investing for 1 week in the biggest mover, in the direction of the move. Earlier, I performed a similar “best of” momentum back test on Forex pairs only.

The return since January 2009 was a positive return of 23%. The best performers were Silver (31%) and the Nikkei 225 equity Index (23%). If we drop down to the second strongest movers, the best performers by far were Crude Oil and Brent Crude, on about 23% each.

It is a simple fact that stock markets and commodities have stronger and longer trends than Forex currency pairs. You should consider whether that is something you could take better advantage of as a trader through brokers offering commodity and share index CFDs.

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