CFD vs Forex Trading - Similarities and Differences
The most popular financial instrument in the trading market is Forex. CFD vs Forex is often a highly sought after topic of interest as traders get confused between the two.
These two financial derivatives are often compared to each other. They have both similarities and differences.
We shall take a look at both of them in this article starting with their definition, features, similarity and finally their differences.
Did you know that you can forex as CFD assets? CFD offers a lot more than forex pairs. You will find out which assets you can trade in this article.
Contract For Differences (CFD): Definition and features
Let’s start with CFDs. As the name suggests, they are a contract that is formed between a buyer and a seller.
They come into a mutual agreement to exchange the difference between the opening and closing price of the asset.
If the price of the asset rises, the seller pays the difference and the opposite happens when the price of the asset decreases.
Keep in mind that the buyer doesn’t own the underlying asset. CFD traders speculate on the price changes of the asset instead.
These changes reflect the market price changes of the asset. This is what makes CFDs interesting to trade. You can trade on them without claiming ownership.
The trading happens over the counter instead of a centralized network. To open CFD position, you don’t need to pay the full price of the asset.
Instead, you pay an initial deposit known as margin. This fee is a fixed percentage of the total transaction cost paid to by the buyer.
The ability to trade on assets using a marginal fee is known as leverage. This makes CFDs leveraged assets.
You can gain huge profits with small investments. Similarly, if the market moves against your position, you will suffer huge losses too.
Another notable feature of CFD’s is they don’t have any expiry dates on them. At the end of the trading day, you can choose to either continue your position or close your trade.
A small interest fee is charged which is known as an overnight fee if you extend your position to the next day.
Speaking of fees, there are other charges related to CFD trading. Spread is the difference between the buying and selling price of the asset.
Another charge is the commission fee which only applies to CFD shares.
CFD Trading Example
To explain how CFD trading works, let’s take a look at an example:
A trader wishes to purchase 5 CFDs of a company where each share is worth $5. The total cost of the transaction comes to $25.
If the margin is set at 10%, he only has to pay $2.5 ($25×0.01) as an initial deposit. This sets the leverage to 10:1.
With CFD’s you can either go long or short. What this means is when you speculate the price of the asset will increase, you go ‘long’ i.e. you buy assets.
In contrast, you go ‘short’ when you speculate the price of the asset will drop. In a nutshell, you can gain profits even when the price drops!
CFDs can be traded like shares, stocks, commodities, indices, and currencies.
CFD traders enjoy the flexibility of trading over thousands of trading instruments from all over the world. CFDs can be used for hedging as a counter-risk measure.
Opening a position opposite your initial position to counteract losses is known as hedging.
There is an option to add stop losses in CFD trades to minimize your losses in case the market position moves rapidly against you.
Forex Trading: Definition And Features
Forex stands for Foreign Exchange. As the name dictates, it is the exchange of currency pairs.
It is a decentralized market like the CFD market where the exchange of currency pairs from all over the globe happens.
The forex market is the largest liquid market in the world. The average value of daily forex transaction amounts to $5 trillion. This is higher than the market of all other trading assets.
The forex market isn’t a physical one. It is rather an electronic market which is open for 5 days a week, 24 hours a day.
The forex market is a fast-moving one, where the price fluctuates every hour or even by minutes or seconds.
You might think this makes the forex market a very volatile market.
In reality, forex is amongst the least changing markets. This is because the price change of currencies on a daily basis is less than 1%.
How traders rake in huge profits is due to forex leverages being as high as 400:1. This makes trading forex pairs profitable if you accurately predict the market price movement.
The price movement in the forex market depends on the supply and demand of the currencies, monetary and financial policies adopted by the governing bodies and political stability.
In forex trading, you don’t own the currency pair. You are instead speculating on the price movement of the currency pair. Check our guides on forex where you can learn about forex trading.
In short, there is no physical ownership of currency involved. Similar to CFDs, Forex pairs can be traded on margin.
3 Forms of Forex Trading
Forex can be traded in three ways; Spot market, futures market, and the forwards market.
The spot market is the most common amongst the three. It involves buying and selling currencies at the current market price.
Forwards and the futures markets do not involve direct trading of currencies.
Instead, a contract is formed between the buyer and the seller dictating the currency and a future settlement date.
You might think forex trading is overly complex but this simple example will help you understand it better.
Suppose you go to a foreign country for vacation. If you need to purchase anything, you need to pay in that country’s currency. When you exchange your currency for their currency, you have successfully completed a forex transaction.
The US dollar is considered as the base currency pair against which other currencies are referenced.
Most forex pairs have the USD as the primary or the secondary currency in the pair. Let’s understand how to interpret a forex pair when you see one.
For example consider the most popular forex pair: EUR/USD. Here Euro is the base currency and USD is the secondary currency.
If the EUR/USD is quoted at 1.20, that means €1 can be traded for $1.20.
Now that we’ve understood how both CFDs and Forex trading works, we can take a look at the similarities between the two.
CFD vs Forex: Similarities
CFDs and Forex have various similarities that we will take a look in this section.
They have more in common than you think. Let’s find out what the similarities between the two are:
Lack of ownership
The biggest similarity between CFDs and forex trading is that traders don’t own the underlying asset.
Instead, they bet on its price movements. In CFDs, the buyer and the seller form a contract and they speculate on the price movements without owning the asset.
Similarly, in forex trading, traders are not buying or selling currency pairs, but rather speculating on its price movement.
CFD and forex both are traded in the Over the Counter (OTC) markets. These are markets where there is direct interaction between the buyer and the seller.
There is no central authority governing these transactions. In an online trading platform, the traders carry out transactions directly.
The trading platforms are regulated by banks or regulatory bodies who are responsible for ensuring fair trading is conducted.
Another similarity between these two is the trading costs. Both carry costs such as spread, rollover fees, and commission fees.
In trading both CFDs and forex, the spread is the difference between the buying and the selling price of the asset.
Rollover fees are also known as overnight fees which is an interest charged to maintain the open position overnight.
In the case of CFDs, the commission is charged only in the case of trading CFD shares.
Trade long and short
When trading both CFDs and forex, you have the ability to go short or long depending on the market position.
That means you can profit from both rising and declining markets.
With forex and CFDs, traders get a lot of flexibility.
Leverage and margin
Both CFD and forex are leveraged financial instruments. That means you can open a larger position using a relatively smaller deposit (margin).
Leveraged trading carries a high risk-reward proposition. Be it forex or CFDs, you have to be careful with high leverage ratios.
CFD vs Forex: Differences
As we have seen these two instruments are quite similar. However, they do differ in certain aspects.
We will take a look at the differences between the two now:
Range of assets
Forex trading is just limited to currency trading.
On the other hand, you can trade CFDs in stocks, shares, indices, commodities, Cryptocurrencies, and currencies.
Yes, you can trade forex as CFDs. We will talk about it in the next section.
In the case of CFDs, the price of the asset is determined mostly by its supply and demand. As supply increases, the price of the asset increases.
In the case of CFDs, as price increases, the demand decreases. The demand for different CFD assets vary as well.
In the case of forex trading, the price change is not limited to supply and demand.
There are other influencing factors such as monetary and fiscal policies, risk, and political stability etc.
Depending on the type of CFD contract, the lot size of the asset differs.
Lot size is the number of the units of the assets to be traded. Hence the lot size is variable for CFDs.
In the case of forex trading, the lot size is always constant irrespective of the currency being traded.
Since CFDs can be traded like stocks, shares, indices, and currencies etc, there are no fixed trading times for CFDs. The duration depends on the type of asset being traded.
However, the forex market has a fixed schedule which is 5 days a week, 24 hours a day.
CFD Forex Trading
We have established that trading currencies are a part of CFDs. When you trade currencies by forming a CFD contract, we call it CFD forex trading.
Spot forex is the most common way of trading FX pairs. In a spot trade, there is an electronic exchange of a currency pair at the current market price.
The exchange happens immediately and the transaction is made in cash.
This is where spot forex differs from CFD FX trading. In CFD forex trading, there is no exchange of cash.
The traders speculate on the price movement of the FX pair instead. They are traded over the counter where the broker acts as the counterparty.
While the spot forex trades happen at the current market price of the currency, the exchange rate for forex CFDs is determined by the broker.
Some brokers don’t match their rates with the actual market price.
In CFD Forex trading, the traders don’t have to worry about the minimum or maximum price of the currency pair.
All he’s concerned about is about if the price is rising or falling from his contracted price. This way he can go long or short respectively.
Advantages Of Trading Forex CFDs
Trading forex pairs as CFDs has certain advantages. We present them here:
Higher profit potential
The forex market is volatile with price fluctuating that can be used in your favor. The level of volatility can be correlated with increased profits.
Higher the leverage, higher the profit potential. In the case of Forex CFDs, the leverage ratio differs from asset to asset.
High market volume
Forex is the most traded financial asset. As discussed previously, the daily forex trade sums up to nearly $5 trillion.
This also means the number of forex traders is endless. You will never have to worry about the best time for trading or finding buyers or sellers. The forex market runs 24/7, 5 days a week.
To open a CFD forex position, you need to pay an initial deposit called margin.
This payment is only a small fraction of your total transaction value. This means you can trade large amounts of money using a small deposit.
Margin and leverage make CFD trading very profitable.
Profit from rising or falling prices.
Even when the price of the underlying asset takes a dip, you can profit from it by going short and selling the asset.
In short, you can profit by going short or long. This makes trading very flexible.
Risk management facilities
You can utilize various tools in CFD forex trading platforms provide to control risk such as stop-loss and take profits.
Stop-loss stops your position automatically after the price reaches a certain value specified by you.
Similarly, take-profit closes your position once you reach a certain level of profit.
The aim of the article was to educate readers on CFD and Forex. Both are financial derivatives which are traded on leverage and margin.
We first discussed CFDs and its features. Then we glanced at forex and the different ways to trade it.
We then compared CFD vs forex together and took a look at their similarities. While they have a lot of similarities, they do have crucial differences between them.
CFD forex trading is slightly different from spot forex trading and we listed their differences. Finally, we went through the advantages of CFD forex trading.
In conclusion, the forex market is a vast one and the limits for profit are endless.
With marginal investments, guaranteed stop-loss orders, ability to go long or short, and ever-increasing demand makes CFD forex trading attractive to many traders.