Forex vs CFDs: How do they interact and what does it mean for traders?

What’s the difference between forex and CFDs?

This is a question we see a lot online. Which is interesting, because it’s based around a mistake in thinking.

See, forex and CFDs are two different things 

•  ‘Forex’ is short for foreign exchange. It’s a market in which you buy or sell currencies against each other. You could compare it to the stock market. 
•  A CFD (Contract for difference) is a method for placing a trade. You can place CFDs on the forex market, but you can also place them on stocks, commodities, and other market assets. 

So, a CFD is more comparable to something like spread-betting. It’s a way to trade.

Whereas the forex market is more akin to the stock market or the commodities market: it’s a market in which you trade.

So, rather than asking about CFDs v Forex, you really should be thinking about whether CFDs are the right way for you to place your Forex trades.

In this guide, we’ll go through everything you need to know about the forex market and CFDs, and how the two interact.   

First, let’s take a look at the forex market

The foreign exchange market is the place where you trade currencies against each other.

And the forex market is simply massive.

It’s the biggest financial market in the world by some distance.

Every single day, trillions of dollars are traded on the forex market, and every single one of those trades is done through what’s known as a currency pair.

If you’ve ever exchanged money for a foreign holiday, you’ll have seen currency pairs before. They look like this:

•  USD/EUR (USD Dollar to Euro)
• GBP/USD (British Pound to US Dollar)
• EUR/JPY (Euro to Japanese Yen)

And so on.

You’ll see in those three examples, that the US dollar appears both as the first and second currency in the pair.

That’s not random. The order in which the two currencies appear is actually very important to you as a trader.

See, when you look at a currency pair, you’re looking at:

• The BASE currency, which is the first currency (USD/EUR)
• The QUOTE currency, which is the second currency (USD/EUR)

It’s important to remember this, because every single forex trade you place will be based on the same principle:

The change in value of the base currency against the quote currency. In very basic terms, you’re speculating on how the exchange rate will change.

So, if you trade EUR/USD, your profit and loss is based on how the value of the Euro changes against the US Dollar.

So, let’s say you open a trade when the Euro is 1.06 against the dollar, and then the value changes to 1.07, the 0.01 is your profit or loss, depending on how you entered the trade.

§ If you went long (you speculated the base currency would increase against the quote currency) then you would profit.

§ If you went short (you speculated the base currency would decrease against the quote currency), then you would have lost money.

So, what are CFDs in forex?

CFDs are Contracts for Difference. 

Put simply, they’re an agreement between you and a CFD broker to exchange the difference in price of a forex pair when the trade opens, and the price when the trade closes.

How you enter the trade (as a buyer or a seller) will decide whether you profit or lose on the forex trade  
 

What does the buyer and seller mean in relation to CFDs?

When you open a CFD trade, you choose to be the buyer or the seller.

• If you want to go ‘long’ on a CFD trade, you want to be the buyer.
• If you want to go ‘short’ on a CFD trade, you want to be the seller.

This might all sound complicated, but all you really need to remember is that:

• If you believe the price of your currency pair will go up, you want to ‘go long’ as the buyer.
• If you believe the price of your currency pair will go down, you want to ‘go short’ as the seller.

An important note on CFDs 

One thing to be aware of when you trade CFDs is that you don’t own the underlying asset. So, when you trade forex CFDs, you’re not actually buying or selling the currency.

CFDs are derivatives. They’re derived from – based on - the market price of the currency pairs.

But, in a CFD, the only actual contract you hold is with the CFD provider.    
 

Why would you trade CFDs on forex?

There are two main benefits to trading forex CFDs:

CFD Benefit 1: You can access higher level trades using less initial capital

Let’s say you want to place a forex trade worth $20,000, but you don’t have $20,000 in capital.

By using leverage, you can place this trade without the initial capital by borrowing the extra money from your broker at a specific ratio.

Now, the most important thing to understand when you use leverage is this:

In a leveraged trade, profit or loss is worked out on the total value of the trade, NOT how much capital you put in.

This means that both your profit and your loss can be larger than your initial stake.

So, let’s say that you make 15% profit on the $20,000 trade we just used as an example.

Your profit would be $2,500.

You put in $1,000 of capital, so although your profit on the trade is 15%, your profit on the money you actually put in is 150%.

However, the same goes for your losses. A 15% loss on the trade would mean that in money terms, you lost 150% - more than double what you put in.

As you can probably see, how much you choose to use leverage is down to your personal appetite for risk.

The more leverage you use, the more potential there is to make or lose much more money than you actually put in.

Either way, you should never trade with money you cannot afford to lose.

CFD Benefit 2: CFDs can allow you to go short or long with the same simplicity

When you trade forex – as with nearly all trades – you can:

• Go ‘long’ if you believe your chosen base currency is going to get stronger
• Go ‘short’ if you believe your chosen base currency is going to get weaker

In some areas of the market, shorting can be a complex process.

CFDs, though, allow you to place long and short trades using the same simple process:

1. You pick your currency pair

2. You choose whether to sell (long) or buy (short)

3. You enter the size of your trade

And that’s it.

It’s important to remember, though, that although placing CFD trades is technically simple, CFDs are still complex trading devices.

Before you use them, you need to take the time to fully understand:

• How to calculate your position size
• How to calculate your risk
• How much leverage to use
• How to calculate your required margin

As well as how to place a trade. 

Here’s the good news:

You can start placing CFD forex trades today, without risking any real money

When you open a trading account with markets.com, you get access to a full demo account complete with synthetic funds.

So, you can place as many forex CFD trades as you need to, without risking any of your real money.

You can take as long as you like getting comfortable with how CFDs work and how to calculate your trades.

Then, when you’re ready, you can start placing trades for real, using the same platform you practised on. (Our demo and live accounts are identical.)