A contract for difference (CFD) is a buyer-seller agreement. In this agreement, the buyer pays the seller the difference. This difference is based on the asset’s value, such as forex trading, at the start of the contract. Additionally, it is compared to the current value of the asset.
A CFD is a type of derivative trade. It allows traders to earn from price changes. However, traders do not need to actually own the specific asset. This makes CFDs a flexible trading option. CFDs have gained popularity in OTC markets worldwide.
How do CFDs work
CFD trading works on contracts mirroring the prices of financial markets, for example a share or currency pair. When placing a CFD trade, you agree to exchange the difference in the price when you open the position and close it. That is why we name it ‘contract for difference’.
If you buy a CFD, you will generate revenue when the asset price increases and lose if it decreases. When selling a CFD, you will earn when the price falls and lose when it rises. To close a CFD trade, you trade in the opposite direction.
What are CFDs in forex?
Forex CFDs are agreements used to trade currency pairs with the use of leverage. The foreign exchange market is highly volatile. As a result, traders often prefer to trade this asset class through CFDs.
This allows them to speculate on both upward and downward price movements. Consequently, CFDs provide more flexibility in reacting to market changes.
Since all CFDs involve leveraged trades, traders need only a small deposit, called margin, to open a large position. However, because earnings or losses depend on the position size, they can be significantly greater than the margin. You must always use solid risk management techniques to limit risk while trading CFDs.
The basics of starting with forex CFDs
All traders should have a basic understanding of the forex market and CFDs before starting to trade. Below are the top five things to keep in mind:
How do CFDs and forex differ?
When opening a trading account with a forex broker, you can trade forex. Specifically, you can speculate on the value of one currency against another, such as EUR vs USD, through CFDs. In this case, you won’t be holding physical currencies.
Instead, you will be using the derivative to speculate on the price movement. This provides a convenient way to engage in forex trading without the need for actual currency exchange.
Forex is always traded in pairs
Forex always involves currency pairs, such as the EUR/USD (euro and the US dollar). When trading, you simultaneously buy one currency while selling the other, based on your expectation of how their values will change relative to each other.
The currency you buy, known as the base currency, appears first, while the one you sell, called the quote currency, appears second.
The price of the pair is the amount of the quoted currency it will take to buy one unit of the base currency. Therefore, if the EUR/USD exchange rate is 1.08795 it means that it will take 1.08795 USD to buy 1 EUR. Remember that CFD forex trading closely resembles trading in the underlying market.
When markets are closed, the movement of the underlying market solely sets forex CFD prices. Otherwise, client sentiment and future market events influence pricing.
Also, to standardize forex transactions, traders trade currencies in lots, which are usually large because forex prices are likely to move in small amounts. 1 micro lot is 1,000 units of the base currency and 1 standard lot is 100,000 units.
Forex CFDs are usually denominated in the quote currency
With a forex broker, you typically trade forex CFDs. These CFDs denominate in the quote currency. Additionally, the broker settles them in the account’s base currency.
For example, when trading EUR/USD, the broker calculates the profit and loss in USD. This is because USD serves as the quote currency in the pair. As a result, any changes in the exchange rate impact the USD value.
Additionally, traders buy and sell forex CFDs at the spot price, which reflects the current market value rather than a future contract price.
Traders can trade majors like the EUR/USD or GBP/USD, minor pairs like the GBP/CAD, or even exotic pairs in forex.
Spot vs options in forex CFDs
Most forex CFD positions occur in the spot market, meaning that traders execute them at existing prices based on the cash price of the currency pair. Foreign exchange options do exist, though.
Options give the option but not the obligation, to purchase or sell an exchange rate of a currency pair prior to a specific predetermined date.
Options expire daily, weekly, monthly, or quarterly, while traders purchase and sell spot forex at prevailing market prices.
Although delivered from the same spot currency pair, FX options may be quite different from one another. Unlike spot forex trading, which has no fixed expiry date but incurs overnight funding charges when traders hold positions beyond a day, forex options do not require overnight fees but have a set expiry date.
Although traders can only trade 9 currency pairs in forex options, the spot forex market provides access to 80 currency pairs, including majors, minors, and exotics.
Having their own set of risks and values, CFDs are used to trade spot forex and forex options. One of the features of CFDs is leverage, where traders can take on larger positions with smaller initial capital. While profits and losses are based on the total trade size and not the margin amount, losses can exceed the deposited amount, even though this can potentially increase potential returns.
Contracts are used to trade spot forex CFDs
Whether you earn or lose from a CFD forex trade depends on multiplying the amount of your position, which is the number of contracts, by the value of one contract. Then multiply that result by the difference in points between the entry and exit points of the trade.
Steps to start trading forex CFDs
1. Learn about CFD & forex trading
Start by becoming familiar with what CFDs are and how they work. You can read some beginner guides on CFDs trading. For forex, you can learn the basics of forex trading so as to have an understanding of the largest financial market in the world. You can explore T4Trade Education for resources designed for all skill levels. You could also practise trading on a demo account.
2. Open and fund your account
Register with your preferred CFD broker and deposit funds to start trading. At T4Trade, there are multiple account types and deposit methods to suit everyone’s needs.
3. Choose your preferred currency pair
Choose from 80+ forex pairs with T4Trade. Use technical or fundamental analysis to assess the movements of the base and quote currencies before choosing your pair. Then you can think of your trading plan. Choose the trading strategy you want to follow and stick to it.
4. Open your position
Once your account is ready and verified, you may place your first trade. Choose whether to buy or sell your chosen currency pair. You would buy if you expected the pair to rise in value as opposed to the quote currency or sell if your expected it to drop. Use tools like stop and limit orders and monitor your positions via alerts and more.
INFORMAÇÃO LEGAL IMPORTANTE: Esta informação não deverá ser considerada como aconselhamento ou recomendação ao investimento, mas apenas como comunicação de marketing.
