Forex vs CFDs: Their Differences And Similarities
Forex and Contracts for Difference (“CFDs“) are popular investment options for many traders across the globe. Both offer several benefits that make them attractive to people looking to succeed in the financial markets. However, many traders are often left wondering which of the two is better. The simple answer is that none of the two markets is better than the other. In light of this, the right question to ask is what are the similarities and differences between the two markets. This way, it becomes easier to determine which market is better suited to your objectives and long-term trading plan.
Overview: What Are The CFD And Forex Markets Like?
With a history spanning back hundreds of years, forex trading is one of the oldest forms of global trade. Today, the forex market is the most traded financial market in the world with a daily trading volume totalling $6.6 trillion. The CFD market is relatively new compared to the forex one, with a shorter history dating back to the early 1990s. However, over the years, CFDs have emerged as an innovative trading instrument and they are now increasingly popular among traders.
CFD Trading vs. Forex Trading: What Are The Differences?
- The selection of instruments
The key difference between forex trading and CFD trading is that while forex is limited to just currencies, CFD contracts cover a broader range of assets. With forex trading, the eight major currencies make up the majority of the trading volume on the forex market. Although many forex brokers will offer traders between 40 and 70 currencies comprising majors, minors, and exotics, CFD trading offers thousands of instruments including currencies as well. Consequently, forex trading tends to be more straightforward because it only involves trading currencies while trading CFDs is generally more complex. Some of the commonly traded CFD contracts are those on forex, equities, indices, and commodities. This gives you access and exposure to a very wide range of trading opportunities including international stock portfolios you may otherwise have been unable to access directly. Additionally, as cryptocurrency gains more popularity as a globally recognised digital asset, cryptocurrency CFDs have also started generating lots of interest in the market.
- Contract sizes
When trading forex, the lot size is uniform regardless of the currency pair you are trading. The standard lot is 100,000 units of currency. Brokers also offer smaller accounts which are a fraction of the standard lot. These are the mini, micro, and nano lot sizes that are 10,000, 1,000, and 100 units of currency respectively. In addition to giving significant flexibility in terms of the instruments you can trade, CFD trading also offers a wide range of contract sizes. Depending on the instrument you choose to trade, you can expect variations in the amount of the asset that makes up one CFD. For example, with metals, one standard contract is 100 ounces while with equities, one standard contract is one share.
- 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.
For example, while the same factors affecting the forex market can also affect CFD prices:
– The earnings of the respective stocks in an index influence the prices of index CFDs such as the FTSE100, S&P500, and the DAX30.
– Crude oil CFD prices are mainly driven by seasonality or the supply and demand for the oil.
– Prices of equity CFDs are largely determined by company-specific events and business factors such as acquisitions and earnings.
– Elements such as the supply and demand for cryptocurrencies and the number of competing cryptocurrencies in the market affect cryptocurrency CFDs.
- The cost of trading
Although the costs of trading CFDs and forex are both partially based on the spread, CFDs tend to involve other costs which vary depending on the trading conditions and the underlying asset being traded. For instance, CFD positions held overnight can incur overnight financing costs. Also, while forex and commodity CFDs will normally only attract the spread as the cost of trading, the transaction costs of equity CFDs may involve commissions.
What Are The Similarities Between CFD Trading And Forex Trading?
- Non-ownership of the underlying asset
Whether you opt for CFDs or forex, trading both markets doesn’t give you ownership of the underlying asset being traded. For example, when currency trading e.g. the EUR/USD, you’re not actually buying or selling euros and US dollars, you’re simply speculating on whether the value of the euro will increase or decrease relative to the US dollar. Similarly, when you trade CFDs, for example, by buying a CFD contract on the FTSE 100, you’re not actually buying and owning the stocks in the FTSE exchange hence the name contract for difference. The same is true if you’re trading a commodity CFD such as oil. You don’t own a barrel of oil, but you merely speculate on whether the oil’s underlying price will go up or down.
- Similar execution processes
Both CFD and forex trading involve similar trade execution processes. The same platform handles the execution of the trades, using similar pricing methods and trading charts. Additionally, a network of banks, rather than one centralised exchange, processes both forex and CFD trades.
- Potential to trade both long and short
One of the main advantages of CFD trading is that you can speculate on price movements not only when the market is rising, but when it’s falling as well. If you think that the value of the underlying asset will increase, you go long on the trade (buy). If you think the value will decrease, you go short (sell). For instance, if you think the price of the EUR/USD is going to increase, you can buy a forex CFD. You will profit if the euro value increases against the US dollar or you will have a losing trade if the euro value falls. Similarly, the high liquidity of the forex market allows for trading during both uptrends and downtrends. In a rising market, you can buy a currency pair at a lower price and make a profit by selling the pair at a higher price when you close the trade. In a falling market, you will do the opposite, selling the currency pair and making a profit by buying it back at a lower price.
- The need for trading essentials
Forex and CFDs are both types of investments in the financial markets and as such, finding success in both markets requires some financial market essentials.
– It’s crucial to have trading know-how in both markets before trading. You will have to know how each market works; from understanding different terms like spread, price gaps and margin calls to know the different types of market analysis methods and everything in between. Both global markets are also dynamic making it important to regularly update and add to your knowledge to keep up with any emerging changes.
– You need to have a sound plan and strategy if you’re going to increase your chances of succeeding in both markets. Without a plan or strategy, your trading will resemble gambling, which is one quick way to fail at trading.
The trading strategy must include robust risk and money management rules and part of the plan must include a lot of practice on a demo account. After all, trading is a skill that takes time to refine.
- Use of margin and leverage
Both CFD trades and forex trades offer access to margin. However, the margin is normally quoted through a leverage ratio when it comes to forex trading. This means that if a CFD contract has a 2% margin, a trader will have to fund their account with 2% of the contract’s total value. On the other hand, for forex trading, the 2% margin will generally be quoted as a 50:1 leverage. A lower margin requirement means less capital outlay with greater potential returns. This is because it allows you to leverage your position more compared to when you are required to deposit a higher margin amount. For example, a 2% margin translates into a 50:1 leverage whereas a higher margin requirement of 10% translates into lower leverage of 10:1. However, with the lower margin comes higher exposure to risk as illustrated in the following example.
Example: The risk of trading with a low margin vs. a higher margin Using forex CFDs to illustrate the effect of different levels of margin, let’s assume two different scenarios; one with a 2% margin and the other with a 5% margin. With a 2% margin Let’s say you have a USD account and the EUR/USD is trading at 1.0831. Your analysis indicates that the EUR will likely weaken against the USD, so you decide to sell three mini contracts of EUR/USD for €30,000, which buys US$32,493. Using a margin rate of 2%, you only have to deposit $649.86 (2% x $32,493), i.e. you control a $32,493 position with just $649.86. If your prediction is correct and the price subsequently drops to 1.0762, you will have gained 69 pips. Each pip in a mini contract is worth $1, so your profit will be $207 (69 pips x $1 x 3 mini contracts). Had you invested the required $32,493, you would still have gained the $207, but it would have been only 0.64% of your capital outlay (100 x [$207/$32,493]). The use of margin allows you to magnify the gains to 30.4% of your initial capital outlay (100 x [$207/649.86]). In other words, you get the same profit at a considerably lower cost. The 2% margin means you get leverage of up to 50:1. Nonetheless, this leverage is double-edged. It can easily magnify your losses the same way it magnifies returns.
– Accounting for the leverage
Continuing with the example, if your prediction is wrong and the price rises to 1.0929, you would lose 98 pips. Your loss would be $294 (98 pips x $1 x 3 mini contracts). Let’s say you had applied all the available leverage of 50:1 to your trade, you would only require a 2% adverse movement (the $649.86) to deplete your capital. In this example, losing 98 pips would mean a loss of 45.2% of your initial capital in a single trade (100 x [$294/649.86]). The general rule is not to risk more than 1% of your account on a single trade. This one trade would have put you at very high risk.
– Leverage with a 5% margin
Using the 2% margin scenario to reflect a margin rate of 5%, the required deposit would be $1,624.65 (5% x $32,493). If the price subsequently increases to 1.0929, the trade would still result in a loss of $294. However, with a 5% margin, you would require a 5% adverse movement to deplete your capital. In this scenario, even if you used all of the available 20:1 leverage, the loss would only account for 18.1% of your account (100 x [$294/$1,624.65]). You would have been in a better position than if you had used the 50:1 leverage. Lower margin and higher leverage, carry higher risk. Generally, you shouldn’t use all your available margin and you should only use leverage when it’s clearly advantageous. Leverage can significantly amplify losses as well as profits, so it’s wise to employ risk management strategies such as stop losses and take profits.
Note: CFD trading carries high risk. Margin calls can be frequent and it’s possible to lose more money than your initial margin and end up with a negative balance unless your CFD broker provides protection against this.
- Available educational resources
For some time, information on forex trading was more readily available compared to CFD trading due to retail forex being accessible to a wider, online audience for a longer period of time. However, as CFDs become more popular, there are increasingly more quality CFD trading resources available to help traders navigate the intricate market. The lack of access to good educational resources is no longer a factor holding people back from entering both the forex and CFD markets.
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Forex vs. CFDs: Which Market To Trade?
When it comes to choosing between trading CFDs or forex, the choice comes down to your preferences, risk profile, and ultimate trading goals. There are advantages and disadvantages attached to both trading opportunities and each market can give you an edge when trading. In some cases, when traders have sufficient knowledge and practice in both the CFD and forex markets, they opt for trading both. By knowing what makes CFDs similar to and different from forex, you can make an informed choice. This will make for a more effective trading strategy and increase your potential to create a successful and rewarding trading career in either or both global markets in the long run. To learn more about how to trade Forex and CFDs, open a demo account with FP Markets and get familiar with our trading platform and the Forex market and CFDs and test your trading strategy on it.