CFDs and forex trading; what is the difference?
While there are some similarities, the two products are very different. CFDs and forex trading are the two most popular instruments on the market and if you are a beginner trader, it’s important you have a clear understanding of how they both work.
By learning more about CFDs and forex trading and what they offer different types of traders, you can make an informed decision on which product is best for you to trade. You’ll then develop a trading strategy that is unique to your trading style, depending on which instrument you choose.
What are CFDs?
CFDs stands for Contracts For Differences. Basically, they are electronic contracts between traders and brokers in which both parties agree to exchange the difference between the entry and exit price of an underlying asset.
CFDs are a popular form of derivative trading that allows traders to speculate on the upward and downward movement of prices of fast-moving financial instruments such as commodities, indices, shares, currencies, and treasuries.
Simply put, CFD trading is a form of price betting on securities and derivatives. A derivative is a financial investment that is derived from an underlying asset. In the case of CFDs, the trader doesn’t take ownership of the asset but merely speculates on whether its value will increase or decrease in a set period of time.
The main difference between CFD trading and investing is CFDs involve speculating on price movements without taking ownership of the asset; while investing means you take direct ownership of the asset.
A CFD is a tradable instrument meaning it is something of value that can be transferred, held, or undertaken. A tradeable instrument has an asset underlying it which traders take a short or long position on to hopefully make a profit on the rise and fall of its price.
CFDs are held between brokers and clients who are either traders or investors. The contract is an agreement between two parties to pay the difference in value of a financial asset between the time the contract opens and closes.
One of the benefits of CFDs is you can trade on margin. This involves borrowing money from a broker to purchase commodities, indices, or stock. Margin trading allows you to buy more of an underlying asset than you would be able to with your own money.
CFDs are flexible. You can go short (sell) if you think prices on the underlying assets will go down or you can go long (buy) if you think prices will go up. CFDs can also be used to hedge an existing physical portfolio.
How CFD trading works is you buy or sell a number of units of an underlying asset based on whether you think (speculate) the price will rise or fall. For every point the instrument moves in your favour (up or down), you gain multiples of the number of CFD units you bought or sold. For every point the price moves against you, you make a loss.
CFDs are popular among day traders who are happy to use leverage to trade assets. CFDs are notoriously risky because it involves trading on margin. This essentially means you are borrowing money that you don’t have to trade CFDs and if you make a loss, you may find yourself in serious financial difficulties.
Did you know?
CFDs are not available to traders via brokers in the United States. This is because it’s against US securities law to trade CFDs in the USA. CFDs are traded over-the-counter (OTC) and this form of trading is heavily regulated in the US through legislation like the Dodd-Frank Act and enforced by the SEC (Securities and Exchange Commission).
What is forex trading?
Forex trading is limited to trading currency pairs on the foreign exchange market. Foreign currency is always traded in pairs, where you have a base currency and quote currency.
The United States Dollar (USD) is the most commonly-traded currency in the world and is usually combined with currencies from the world’s biggest economies to create major currency pairs.
The five major currency pairs are:
- USD/JPY US Dollar/Japanese Yen
- EUR/USD Euro/US Dollar
- GBP/USD British Pound Sterling/US Dollar
- EUR/GBP Euro/British Pound Sterling
- USD/CHF US Dollar/Swiss Franc
Traders buy and sell currencies without physically owning or handling the currency. They make or lose money on the differences in base and quote prices from when a position is opened and closed on a currency pair.
Each currency pair has a bid and ask price. The bid price is the maximum price a buyer is willing to pay for the currency. The asking price is the minimum price a seller is willing to accept for the currency. The bid-ask spread is the difference between the buy and sells price of the two currencies.
Forex trading can be traced back to ancient times where traders swopped one country’s currency for another currency. Today, global currencies are exchanged mostly for commerce, trading, and tourism. The difference is forex traders don’t own the underlying asset, they only speculate on price movements.
Forex is the largest and most liquid market in the world. It’s estimated over 5 trillion US Dollars are traded every day on the forex market. Trading occurs 24 hours a day/five days a week. Forex trading is available through spread betting or CFD trading. Both are leveraged products which mean traders are only required to place a percentage of the full trade value (known as the margin requirement).
How CFDs and forex trading are similar
Both CFDs and forex are traded ‘Over The Counter’ (OTC). This means they are traded via a dealer network through an electronic trading platform as opposed to a centralised financial exchange.
CFD and forex traders do not own the underlying asset that is being traded. A trader does not sit with a vault full of gold, coffee, bond,s or US Dollars after a successful trade. They merely speculate on whether its price will rise or fall without ever taking ownership of the assets.
CFD and forex traders can easily enter or exit the market in both rising and falling markets. There are almost no barriers to enter the CFD and forex markets and because they are both highly leveraged products, you can trade the instruments without being required to put up the full value of the transaction.
To trade CFDs or forex, you need to go through a broker. These brokers offer a selection of trading platforms that give you access to the global CFD and forex markets. The most popular trading platform is MetaTrader 4.
CFDs and forex trading are pretty much on par in terms of costs. This is predominantly the cost of the fixed or variable spread. The spread refers to the difference between the bid (buy) and asks (sell) price of a currency pair. Brokers make money when the trader pays the spread and the majority do not charge commissions or finance fees. However, watch out for hidden costs that add up when trading CFDs and forex.
Trading other types of instruments involves commissions and finance fees. While most brokers entice new traders with the promise of no transaction costs (exchange fees, regulatory fees, data fees, or commissions), you need to be aware that there are hidden costs in forex trading in the form of very small commissions.
Both instruments can be traded in liquid and illiquid markets. In rising and falling markets, CFD and forex traders can choose to go long (when the value is expected to rise) or short (when the value is expected to fall) on positions.
CFD and forex trading are executed on the same electronic trading platforms, using the same type of charts, fundamental and technical analysis,s, and indicators. Trading CFDs and forex is done entirely over an electronic platform via a dealer network. The most popular trading platform for CFDs and forex is MetaTrader 4 (MT4).
Neither the CFD nor the forex market is highly regulated. In both industries you get good, reputable brokers and you get very dodgy brokers. It’s important that you check out a CFD or forex broker’s credibility and reputation before opening an account and starting to trade through the company.
Both CFD and forex trading come with a high-risk warning. Both are leveraged products that expose traders to greater potential profits but also greater potential losses. In fact, due to the risks involved in CFD trading, the product is banned and unavailable to traders in the United States.
How CFDs and forex trading are different
The biggest difference between CFDs and forex trading is CFDs cover a diverse range of instruments such as commodities, indices, currencies, and stocks. Forex is limited to trading currency pairs.
You can always expect variations in the base currency and the lot sizes when trading CFDs. Whereas, with forex, the lot size is always uniform regardless of which currency pair you trade.
CFD trading is influenced by factors such as the supply and demand of an underlying asset or micro-economic or cyclical trends in the business sectors. Forex is driven largely by macro-economic or global events that impact the strength of a currency in a pair. This ranges from international political events to environmental, social,l and domestic factors that boost or undermine confidence in a currency.
CFDs are cheaper to trade than forex but they are subject to capital gains tax. Forex earnings are not taxed per se as they are traded OTC via a dealer network. However, earnings from forex trading must be declared on your annual tax returns.
Pros and cons of CFD and forex trading
CFDs and forex are both exciting, fast-paced markets and relatively easy for beginners to trade. However, don’t let promises of easy money fool you. CFDs and forex trading are associated with high risks and you could potentially lose a lot of money trading these two products if you’re not careful.
CFD and forex traders have easy access to global markets via a network of brokers and popular trading platforms. Trading these products requires lower margins and there is the added benefit of no shorting or day trading regulations and little or no fees.
Pros of CFD and forex trading
You can trade short and long positions on both products. Short positions offer more trading opportunities.
CFD and forex trading are instantaneous. You can open and close positions promptly whereas trading traditional financial assets takes time because they’re more complicated. The speed at which you can open and close positions offers more trading opportunities and allows you to react quickly to trending market conditions.
CFD and forex brokers make money from spreads. Most do not charge commissions or finance fees. You’re also not charged a fee to open and close positions. However, watch out for hidden costs in CFD and forex trading.
You can trade CDFs and forex using leverage. This allows you to take out a much larger position for a smaller amount of capital. Leverage is associated with high risk and can be dangerous for the initiated trader. Leverage magnifies profits but it can also magnify losses.
Cons of trading CFDs and forex
The CFD and forex market is highly leveraged and this is possibly the greatest risk associated with trading these two products. While trading platforms offer stop-loss methods to minimise risk, traders who find themselves overleveraged are at risk of losing a considerable amount of money if trades do not move in their favour.
The CFD and forex market is fast-paced and you can open and close positions rapidly. This makes it very easy to overtrade CFDs and forex. Inexperienced traders need to spend time trading on a demo account and then a mini account before switching to a real trading account in order to develop their trading strategy and adopt a disciplined, unemotional trading style.
CFD brokers charge a financing fee if you hold a CFD position overnight or over the weekend. They do this to pass on the interest they have to pay to keep a position open. Some forex traders promise you a ‘no fee’ deal but sneak in hidden costs in the form of small commissions or financing fees. Watch out for hidden fees on CFDs and forex trading because they can add up quickly and diminish any gains you make.
As mentioned, leverage is both a benefit and a curse of CFD and forex trading. Leveraged trading is risky and you should only trade on leverage with real money once you’ve come to grips with the complexities of CFD and forex trading. As a new trader, you should start out with as low leverage as you can and choose a trading platform that allows you to choose the amount of leverage required on a trade-by-trade basis.
FOREX TRADING AFRICA DISCLAIMER
Trading foreign exchange on margin carries a high level of risk and may not be suitable for all investors. Forex trading involves a high degree of leverage which increases the risk associated with forex trading.