Abstract：Contracts for difference (CFD) trading and forex trading are popular among traders because the two are both amongst some of the highest leveraged forms of trading around.
Foreign currency exchange is officially the oldest form of trading in the world with a history dating back for many thousands of years, while CFD is a relatively new market by comparison, with a history spanning just about 20 years.
However, it can be difficult to fully understand the advantages and disadvantages of investing in and trading CFD particularly for traders at the start of their trading journey. In this article, we are going to take a look at the trading principle of CFD, and the similarities and differences between Forex vs CFD.
What is CFD？
A CFD is a contract between a buyer and a seller that stipulates that the buyer must pay the seller the difference between the current value of an asset and its value at contract time, enabling investors to speculate on financial markets such as shares, forex, indices and commodities without having to take ownership of the underlying assets.
One of the big attractions of this type in investing is the flexibility it allows for. With traditional trading, you are tied to buying the asset basically for it to move in one direction, up. With CFD trading though, you choices are much more open. You can speculate on movements up or down when you buy in to the contract.
For every point the price of the instrument moves in your favour, you gain multiples of the number of CFD units you have bought or sold. For every point the price moves against you, you will make a loss.
Similarities And Differences of CFDs and Forex
There are some areas of these two markets which overlap and a few similarities, but on the whole, they are two very different opportunities. Where Forex is explicitly concerned with trading in currency pairs, CFDs also include currency as the medium, but there is a whole host of other options too.
Similarities of CFDs and Forex
1. Leverage
Both forex and CFD trading are leveraged trading activities. This means that it is possible to open positions which are larger than the traders capital can ordinarily carry.
This is because of the extra capital that is provided by the brokers in the form of leverage for every trade that is executed on a forex or CFD platform.
2. Avoid the transfer of physical assets
Both CFD and forex trading avoid the transfer of physical assets. They both trade over the counter (OTC), meaning that their transactions are decentralised and take place through a network of financial institutions. Their trades are also typically executed the same way.
3. Going long or short
Both markets allow you to go long or short on positions. This is one of the distinct advantages of trading forex and CFDs. Traders can speculate the price movement in any direction. These markets are highly volatile and prices go up and down. If you think the financial asset is going to do well, then you can go long, i.e. buy. If not, then you believe the asset is going to lose value so that you can go short, i.e. sell.
4. Cost
Another similarity between CFD trading and Forex trading is that the only cost of trading is the spread, as opposed to other types of trading instruments that charge commissions and other finance fees.
Differences of CFDs and Forex
1. Underlying assets
The main differences between Forex trading and CFD trading are that Forex offers pure currency trading whereas CFD trading involves different types of contracts covering a diverse set of markets, such as indices, metals, and energy. FX trading is about trading one currency against another currency and always traded in pairs and involves trading in uniform lot sizes.
2. Trading time
The CFD trading does not adhere to the famous “24/5” model of forex trading (which only means that trades can be made 24 hours a day throughout the work week). CFDs instead are bound by the trading hours of the market relevant to the specific asset at hand.
3. Market Influences
Different factors affect the CFD and forex markets. The price movements in the forex market are mainly influenced by global macroeconomic events and economic factors. This can include aspects such as large employment shifts in a particular region, risk sentiment, monetary policy expectations and how they influence the GDPs of the countries whose currencies are being traded, international political changes, and to an extent, environmental factors.
The price fluctuations in the CFD market, on the other hand, depend on the specific factors influencing the instrument being traded. This can include factors such as trend changes associated with a particular business sector or the supply and demand of a given commodity.
Pron and Cons of CFD Trading
Prons:
1. Accessible to more markets
The most important one of them all is the fact that the CFD market gives access to a whole new world of opportunities, other than the Forex market. And everything can be done on the same trading account.
2. Profit from falling markets
To open a short CFD position, you sell your chosen number of contracts instead of buying them. Then, when you want to close your trade, you buy the same number of CFDs.
Doing this enables you to profit when markets fall in price, which adds a whole extra dimension to your trading.
3. Trade using Leverage
CFDs let you trade using leverage. This allows you to control a much larger position with a smaller amount of capital. Some stocks barely move, so unless you have an insane amount of capital invest, you're not going to profit much from a trade. Leverage does allow you to potentially make larger profits from small market movements. Obviously this doesn't come without added risk, and I go more into that in the cons.
Cons:
1. You can lose everything you invest
Stocks rarely drop to zero. Stocks also have a habit of recovering after suffering losses. With CFD trading, if your position drops below a certain point it will just close out. Without any chance of recovery.
2. Rigid Margin Requirements
Unlike other forms of leveraged trading, such as forex, the margin portions of CFD transactions are set firmly by the broker, who decides what percentage of margin youre required to stump up for access to a given market. This can be obstructive to your wider trading plan, and introduces an additional layer of planning into the pre-trade process in order to determine how feasible a potential return may be.
3. You can easily overtrade
Because of the speed of CFD trading, its very easy to overtrade. Overtrading is one of the big mistakes new traders make. And this is something I see happen all the time on CFD platforms. Traders who don't have their emotions in check can easily keep opening positions or even worse opening and closing positions for tiny profits. Both big mistakes.
