To the general population, CFD and forex trading might look fairly similar. As a result, most amateur traders could find it difficult and also confusing to ascertain which market will be ideal for them to get started with.
Right off the bat, you must understand that the two are distinct trading markets despite the multiple similarities between them. If you are considering trading either of the two, you should know the two fairly well, the initial capital requirements, the pros and cons attached to them, etc. Most importantly, you should be aware of your own trading risk profile.
What is Forex?
Foreign currency exchange entails changing a particular currency into another for different reasons, typically for commerce, tourism, or trading. Exchange of foreign currency is arguably the oldest trading form, with a history that dates back several thousand years. Forex is one of its manifestations, which is a popular trade that takes place in trillions of dollars on each working day worldwide.
The forex market is the place where currencies get traded. Why are currencies traded? Currencies need exchanging so that people can perform foreign business and trade. If you live in the United States and would like to buy French cheese, either the company buying the cheese or you must pay the French in euros for the cheese. In other words, you or the American importer must exchange American dollars for euros.
Similar is the case with travel. A British tourist in Egypt cannot pay in pounds to visit the pyramids since the sterling pound is a currency not locally accepted in Egypt. In other words, the tourist will have to exchange the pounds for Egyptian currency, or the Egyptian pound.
One key aspect of forex is the absence of any central marketplace. Currency trading is instead carried out over the counter, electronically. This means all transactions take place through digital networks that connect traders across the globe. The forex market functions round-the-clock Monday to Friday and half day every Saturday. Currencies get traded in major financial centers worldwide.
When trading currencies in a forex market, the currencies are always listed in pairs. Also, there is a price attached to each pair. If, for example, the USD/CAD currency pair has a 1.256 price, it means you will need CAD 1.2562 to buy one American dollar. In case the price goes up to 1.3338, you would then have to pay CAD 1.3338 to buy a USD. This price difference indicates the US dollar has gone up in price in relation to the Canadian dollar.
What is CFD?
Contracts for differences (CFDs), compared to forex, are relatively new as they’ve been around only since 2003. However, within this short period, CFDs have gained tremendous traction and are now a trading option worthy enough to be compared with forex.
CFDs provide traders the opportunity to benefit from movement in price without owning or buying the underlying asset. It’s a fairly straightforward security computed by the asset’s dynamics between entry and exit of the trade. Only the change in price is computed. The value of the underlying asset is not taken into account.
This is made possible thanks to an agreement between a broker and a client. There is no stock, commodity, futures, or forex exchange being used. Trading CFDs provide many important benefits, which have increased the popularity of CFDs in a relatively short period.
How does CFD work? If a stock comes with a $25 asking price and a trader buys 100 shares of that stock, the transaction’s total cost will be $2,500 plus fees and commission. This trade needs $1,250 at least in free cash in a margin account, with the CFD broker requiring a margin of just 5%.
A CFD trade would show a loss equivalent to the spread’s size at transaction time. In case the spread is 6 cents, the stock must gain 6 cents for the trading position to hit break-even. While you would see a gain of 6 cents if you had outright bought the stock, you will have also incurred a bigger capital outlay and paid a commission.
Forex and CFD Trading Payments and Losses
Forex is available 24 hours a day through certain worldwide exchanges. The trading is carried out by three sessions a day every weekday. Since currency is very sensitive to global economic and political happenings, the forex market isn’t necessarily stable. As a result, finishing off a trade at the most opportune moment could result in a huge payout, particularly if there is high leverage at play for increasing investment potential.
The forex market could change its course within seconds. This means what seemed like a certainty could transform completely and lead to a huge loss. Multiple tools can help reduce this loss potential or the transactions’ impact. As a forex trader, it’s imperative you are wary of the various implications.
CFD trading doesn’t need or isn’t confined to a particular marketplace. By taking up CFD trading, you are essentially picking up a contract that reflects how you view any current economic scenario. CFDs, as aforementioned, could deal with currencies but they are also related to shares, stocks, commodities, and even cryptocurrencies. Leverage, as with forex, could be used for investing above the margin and receive a much greater payout theoretically for a smaller investment.
CFDs, however, have a bad rep that links to their earlier days when they were mis-sold as some investment vehicle to make quick and big money. Unfortunately, several amateur investors who fell for that and lost a lot of money within hours still have bad CFD taste in their mouths.
The Cost Component of Forex and CFDs
Both forex and CFDs have certain expenses to boot. Those include exchange or broker commissions and fees, which should be accounted for when you compute the investment potential for the two.
Forex is tax-free; however, each trade’s actual cost isn’t known until it is complete. Transaction costs, broker fees, wider spreads, and commissions could add up soon and grab a fairly large sum of the profit you expected at large.
With CFDs, the costs are fewer since you are taking up a trading contract based on ‘differences’ in value of the underlying assets, instead of any particular value during the trade’s lifetime. Your CFD stays unperturbed by any changes in the underlying asset’s value. In the end, it’s the result that matters the most.
Having said that, you must know that CFDs get subjected to capital gains tax and also predicted commissions and fees. There is, however, no stamp duty.
Trading Forex and CFDs – The Similarities
There are multiple similarities between forex and CFD trading since forex and CFD contracts are over-the-counter (otc) derivatives.
Arguably, the biggest similarity between the two is the trader of either does not own the underlying asset. For instance, when a trader purchases EURAUD, he/she is not technically purveying Euros and Australian dollars. The trade is basically being carried out based on currency exchange rate speculation. Similarly, when a trader buys a CFD contract, the trader doesn’t own the stocks but is rather speculating on the underlying price. In several ways, forex is just another type of CFD.
Both trading types entail a similar trading process. As a trader of either, you can easily enter or leave the market during both rising and declining phases.
Both forex and CFD trades are done on a fairly identical platform, employing similar-looking pricing techniques and charts. In both cases, trades are done in the OTC (over the counter) market. They are electronically run using a linkage of banks. There is no central exchange or physical location.
Another similarity between the two is that ‘spread’ is the only trading cost. This is unlike trading instruments of other types that levy various finance fees, such as commissions.
Trading Forex and CFDs – The Differences
The major difference between forex and CFD trading is Forex offers currency trading options only. CFD trading, however, deals with different kinds of contracts that cover an array of markets, including energy, indices, and metals. When trading CFDs, you can choose contracts based on their currency type and increment value, and also the country of origin of the underlying asset. Forex trading is trading a particular currency against another. Also, trading is done in specific lot sizes.
The other points of differences between the two revolve around general factors that typically influence various markets. Specific factors usually influence CFD trading, which includes a given commodity’s supply and demand or the changes in trends linked with business markets or sectors. On the contrary, forex trading is driven primarily by global events, such as international political changes or major employment shifts.
Forex and CFD Trading – Definitive Pros and Cons
Both CFD and forex are popular trading options in their own rights and on various levels. If used to their highest potential, both could be highly advantageous. As far as potential gains, losses, and trading expenses go, there is not a thick line demarcating the two.
However, neither are truly straightforward trading choices to make. It’s, therefore, imperative to learn more about and fully comprehend the assets underlying so that you know beforehand when a potential loss is coming your way and/or what sources to tap to make the maximum out of your trades.
Compared to forex, you may have to resort to a lot more research for effectively trading CFDs. This may be due to the relative newness of the trading form. However, the major reason is likely to be the various trading options CFDs offer and the potential pitfalls.
Let’s summarize and list the advantages and disadvantages of the two.
Forex
• A tax-free, strongly established trading form
• Unlimited payout potential
• High learning curve
• Hidden end-of-trade expenses with each transaction
• Unpredictable and fairly volatile
• Possible losses without any fallback option
CFDs
• A greater number of options for potential trades
• Lower broker commissions and spread fees
• Most brokers do not charge anything for individual trades
• Less payout potential compared to forex
• Lower leverage since there isn’t any advantage or disadvantage linked to asset price changes
• No proper research could cause an inexperienced trader to fall prey to the nefariousness of certain brokers, besides incurring losses such as overpaying fees
Which Trading Type Would Suit You the Best?
Both forex and CFD offer exciting trading opportunities. However, as mentioned before, there are pros and cons to both. You can possibly resort to both forex and CFD trading simultaneously. However, it’s recommended you don’t do that. Confine your trading activities to one, at least initially. Once you get a hang of things or are fairly comfortable with either of the two, you may start to roll with the other trading type.
The forex market, particularly in its modern avatar, is pretty well-defined or well-structured as far as trading platforms go. The tools for assistance with risk management and analysis are pretty seamless too. There are also little to no barriers to entry associated with forex trading.
Moreover, since forex trading has been around for decades, more than enough amount of information and past analytical data are available in different forms and shapes, right from traditional and digital books to online videos. If you are new to forex trading, all of this freely available information will help you navigate the intricacies attached to forex strategy formation fairly well.
Information pertaining to the CFD trading world is not as easily or readily available comparatively, thanks to the fairly nascent status of the market. Therefore, if you are just getting started, you may find it a tad difficult to locate the right tools for CFD trading analysis. You may have to work pretty hard to locate platforms suitable for trading. Most proponents of CFDs may state otherwise, which is not true.
Conclusion
There are certain areas in which forex and CFDs overlap and have quite a few similarities. However, on the whole, the two are fairly diverse trading opportunities. While forex is primarily concerned with currency pair trading, CFDs are more than just about currencies. CFDs present a host of other trading opportunities too. You need to be wary of these aspects before proceeding with either.
