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What are CFDs in forex and how do they differ from forex trading?

 

The first thing you need to understand is that CFDs are a method of making a forex trade.  

Let’s break this down so it’s easy to understand.  

Forex is short for foreign exchange. So, when people say ‘the forex market’, they’re talking about the foreign exchange market.   

When you trade the forex market, you’re essentially trading currencies against each other in what’s known as ‘currency pairs’.  

When the two currencies change in value against each other, you can experience a profit or a loss from that change.   

Let’s say the exchange rate between the US dollar and the British pound is 1.3.  

You buy £10,000 at a cost of $13,000.  

Then, the exchange rate rises to 1.4. So, you sell the £10,000 back, and you now receive $14,000 in return. 

You’ve made a $1,000 profit simply due to a change in strength from one currency against the other.  

This is a simplified example, but it should show you how it’s possible to make or lose money from currencies that change in value against each other. This is an example of a simple forex trade. 

CFDs are a way of placing a trade like this one.  They’re a method. (Another method would be spread-betting*.) 

Forex, meanwhile, is a market.  

In fact, it’s the biggest single trading market in the world, with trillions of dollars being bought and sold each day.  

For some perspective on just how big the forex market is, take a look at this chart from Alpari: 

 

What are CFDs in forex and how do they differ from forex trading?

 

 As you can see, the forex market dwarfs the world’s major stock markets.  

 

What is forex CFD trading? 

CFD stands for ‘contract for difference’, and as we mentioned earlier, it’s actually a method of placing a forex trade. (Other methods would include spread-betting and spot-trading.) 

A contract for difference – as the name suggests – is an agreement between you and a broker to exchange the difference in an asset’s value between when the contract opens and when the contract closes. 

That might sound a bit wordy, but it’s not as complicated as it sounds. (Which is one of the reasons CFDs are popular with forex traders.) 

Here’s a CFD forex example:

Let’s say you trade the currency pair of USD/GBP.

Currently, you can get 1.23100 dollars to the pound. 

You open a $10,000 position as a ‘long’ trade. 

Over the next three hours, the price of USD/GBP moves to 1.23000.

The price has moved 100 points in your favour. In this case, 100 points means $100 dollars in profit. 

 

Another way to work out your profit is: 

Position Size x Opening Price ($10,000 x 1.23000 = $12,300) minus position size x closing price ($10,000 x 1.23100 = $12,310) = Profit ($100 in this case). 

Again, this sounds more complicated than it is. Once you’ve gone through a few trades yourself, you’ll get the hang of it.  

But as you can see, the difference in price between when you open the trade and when you close it forms the basis of your profit or loss.  

 

The buyer and the seller 

All CFD trades have a buyer and a seller. 

If you believe the asset will go up in value, you want to be the buyer.  

Let’s say you ‘buy’ a forex pair and it increases by 20 points. When you sell it back, that 20 points (and whatever it represents in terms of money) is your profit.  

If you believe the asset will go down in value, you want to be the seller. 

You ‘sell’ a forex pair which then falls by 20 points. This means you can then buy it back for 20 points less than you sold it for, again pocketing whatever the 20 points represents in monetary terms.   

It sounds a bit strange when phrased like that, but the simple way to remember it is that if you want to place a ‘long’ trade, you want to be the seller, but if you want to short, you want to be the buyer.  

 

Is trading CFDs in forex a good idea? 

 

What are CFDs in forex and how do they differ from forex trading?

 

It depends on what your goals are.  

If you want to be able to place long and short forex trades using the same step-by-step process, then CFDs could be ideal for you.  

However, CFDs in forex carry specific risks. Risks you need to understand thoroughly before placing any trades yourself.  

 

What are the risks and disadvantages of CFD trading? 

The main risk of using CFDs comes from leverage. Nearly all CFD trades use leverage in some capacity, and it can be a useful tool. But it can also be very risky.  

Leverage is a trading tool that allows you to enter higher value trades even if you don’t have the full capital required.   

Again, that might sound complicated, but let’s go through an example: 

So, let’s say you want to open a trade worth $10,000. However, you don’t actually have $10,000 in your trading account.   

Your broker allows you leverage of 20:1. This will allow you to enter the trade with much less starting capital. 

To work out the capital needed, you simply divide the size of the trade ($10,000) by the first figure in the leverage calculation (In this case, the leverage is 20:1, so we use the 20 figure.)  

So, $10,000 divided by 20 means that you would need $500 to open this trade. Plus your trading margin. 

As you can see here, leverage means you can potentially target higher profits than you would if you were limited to only trading with your real capital.  

BUT. It is very important to understand that leverage also opens you up to bigger losses. You can always lose more than the capital you put in.  

When you use leverage in a CFD trade, any profits or losses are calculated on the total value of the trade, not on how much money you actually put in. 

So, if you use leverage to open a CFD trade with a value of $20,000 using only $500, your profit or loss is calculated on the $20,000, not the $500.  

If you made 15% on the trade, your profit would be $2,500. But if your trade fell by 15%, your loss would also be $2,500, despite having only traded with $500. 

This is what we mean when we say leverage can lose you more than your initial stake. 

 

How to trade CFDs on forex markets

To trade CFDs on forex markets, you need to sign up with a broker. 

Brokers – otherwise known as ‘market providers’ – are the people with whom you open the CFD. They provide the contract. 

See, when you trade CFDs in forex, you’re not actually buying and selling the currency for real. When you “sell” £10,000, you’re not actually selling that money – you’re just opening a contract based on how well that currency performs.  

CFDs are what’s known as ‘derivative’ financial products. They derive their value from the value of the asset. 

In a sense, they’re a kind of speculation on how a currency pair will perform, with the broker playing the role of the ‘house’. 

The broker will set up the contracts, and allow you to place the CFD trades using their platform.  

(It’s worth highlighting that any CFDs are not officially classed as gambling, and any profits you make may be taxable.) 

Start Trading Now

 

Is trading CFDs safe? 

No form of trading is risk-free, and that’s certainly the case for CFDs.  

If by ‘safe’, you mean that you can’t lose money by trading CFDs, then no, CFDs are not safe.   

When you trade CFDs, even if you’re profitable in the long run, you will have losing trades. If you’re not comfortable with the idea of losing money on some trades, you shouldn’t trade full-stop. 

 

Is CFD trading good for beginners? 

CFDs are technically simple to execute.  

You decide whether to go long or short, you input your position size, and then you trade. 

That’s it. 

In that sense, CFDs can be suitable for less experienced traders.  

However, as you’ve seen in this guide, CFDs are also complex. They require some work to understand.  

This, combined with the use of leverage, means that if you’re a beginner trader, you should take the time to thoroughly understand how CFD trades work before you place any for real.  

It’s important to understand: 

  • How to calculate your position size 
  • How to calculate your margin and leverage 
  • How to work out what capital you want to risk  
  • How to evaluate the risk of the trade  
  • How to evaluate the performance of your trades 

And, of course, you need to know how to place the trades accurately.  

How to practise placing CFD trades with no risk 

At markets.com, when you sign up for one of our trading accounts, you will get automatic, free access to one of our demo accounts, complete with synthetic funds.  

You can place as many fake CFD forex trades as you like, without risking any real money. 

This will give you the chance to build up your confidence and ability until you’re ready to trade for real. (When you can simply transfer to your full account.) 

All you need to do is sign up to one of our demo accounts.

Start Trading Now

 

In Summary: 

  • CFDs are a method of placing a forex (foreign exchange) trade 
  • The forex market is the biggest single trading market in the world 
  • CFD stands for ‘contract for difference’, it’s an agreement between you and a broker to exchange the difference in an asset’s value when the trade opens and the value when it closes 
  • CFDs use leverage, which is high-risk. 
  • To trade CFDs on forex markets, you need to open an account with a registered CFD broker 
  • CFDs are legal, but they are high-risk. If you’re not comfortable losing money on some trades, you shouldn’t use them.  
  • Beginner traders should make sure they understand CFDs thoroughly before using them.  

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