Forex CFDs: what are they and how do they work?
Contracts for difference (CFDs) are financial derivatives which allow traders and investors to speculate on the price movement of assets, without owning the underlying asset itself. This includes currency pairs on the foreign exchange (forex) market.
The forex market is the largest and most actively traded financial market in the world and experiences, on average, $6 trillion worth of trade every day.
Trading forex CFDs can be a great way to diversify your portfolio, as well as a potential way to prevent losses when owning the real assets.
What is CFD trading?
Before trading forex CFDs, it’s worth understanding how CFD trading works in general. According to Skilling, an online forex and CFD trading platform, this type of trading is defined as a:
“a popular form of trading on the financial market… In contrast with traditional investments, CFD trading allows traders to take positions on falling prices as well. [It] also gives investors access to the global markets – such as shares, indices and commodities – in a single trading environment.”
The contract, sometimes known as a unit, acts as an agreement between the investor and CFD trading platform or broker. The results are determined by the difference in opening and closing price of the contract, and the trader would profit or incur a loss, accordingly.
With forex trading, you do not own the underlying currency pair, but instead can speculate on their price movement in the market. Because of this, investors can sell forex CFDs and profit when prices fall, or lose when prices go up.
What are currency pairs?
In order to understand forex CFDs, it’s important to know about currency pairs — the way in which the underlying market is traded. Traditional forex trading consists of currency pairs, formed by two currencies, as the name suggests. These are the base and quote currency.
Let’s take the example of the Euro and US Dollar (EUR/USD). EUR is the base currency on the left, and the asset you’d be buying in. USD is the quote currency on the right, and what you’d be selling in. The exchange rate is reflected in the quote currency.
When forex trading, if the EUR was to strengthen against the USD, then you would make a profit. However, should it fall against the USD, then you would incur a loss.
A key element of forex trading, for both CFD trading and traditional trading, is to keep up to date with events and factors which can impact the market, and value of the currency pairs.
Trading forex CFDs
Through CFDs, traders can speculate on the forex market when its falling as well as rising — which differs to traditional forex trading. When taking a position on the market through CFDs, you can either go long or short.
If you speculate the value of the relevant currency pair shall rise, then you will buy your chosen number of CFDs, also known as units. If you predict the market will fall, then you will go short and sell your units.
You’ll be presented with the price of the units through your chosen CFD trading platform, which is called the bid price. When there are discrepancies between price and the offer price — the actual price you pay for the units — this is known as the spread. Tighter spreads can be a benefit of a good CFD trading platform.
Including CFDs as part of your investment portfolio usually forms part of a short-term strategy, and can be a good way to diversify your investments, or hedge against potential losses when trading traditionally.