What is CFD Trading in Forex?

What is CFD Trading and Why Should I Choose it?

Contracts for Difference (CFDs) are a popular form of derivative trading that can be used to trade most financial instruments, including forex, stocks, indices and commodities. A CFD is a contract or agreement arrived at between two parties to settle the contract at the difference between the opening and closing price of an instrument, at a specified date and/or time. What makes this form of trading popular is that it can be used to speculate regarding both rising and falling prices, giving the trader an opportunity to earn from even a bear market. Another aspect that attracts traders to this type of derivative trading is that you don't need to actually own the underlying asset to speculate on it.

Source: Forex & CFDs / Admiral Markets / 03/08/2018 (https://admiralmarkets.com/start-trading/contract-specifications)

With CFDs, you can actually enter into a contract that is much larger than the amount of capital in your trading account. This is enabled through the leverage that brokers offer on CFDs. The leverage can go as high as 500:1. However, be careful. While leverage allows you to gain much higher exposure than the capital you have, it could also lead to high losses if the price movement does not go in your favour.

Is Forex the Same as CFD?

Forex essentially refers to currencies. So, if you are trading forex, it means that you are purely speculating on the change in the exchange rate between two currencies. On the other hand, you can enter into a CFD in different markets, from shares to commodities and precious metals, apart from forex. When you trade forex CFDs, you are speculating on the change in value of a single currency over a period of time. The good news is that just like trading forex, you also have very effective trade tools for predicting price movements when you trade CFDs. However, before you invest your hard-earned money, here are some things you should know about this form of trading.

How to Trade CFDs

Just like trading any other financial instrument, you need to understand the market and be able to use the right trade tools to predict future price movements. So, the first step is to choose the market you want to trade in, not just in terms of the asset you wish to trade but also which global market you are interested in, such as the UK, US, Asia, Australia, etc. Once you've made your first decision, now you are ready to begin.

Go Long or Go Short

The next decision you need to make is whether you want to buy or go long versus sell or go short. Just as in trading forex, CFDs also have a bid and ask price. The difference between these two prices is the spread. So, while the price of your CFD depends on the underlying instrument, what you actually speculate on is whether the price will go up or down. If, using technical and fundamental analyses, you believe that the market is likely to go up, you go long or buy. On the other hand, if the trade tools indicate the potential for price decline, you sell or go short. So, this decision, just like the choice of instrument and global market, is based on adequate knowledge, research and analysis.

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Source: Market Analysis / Pixabay / 31.7.2018 (https://pixabay.com/en/chart-trading-courses-forex-1905224/)

Choose Your Position Size

Given the availability of leverage for CFD trading, it is very tempting to take a position size that is large. However, remember that when you increase your exposure, your potential for both profit and loss increases. For all types of trade, the larger the value of your trade size, the greater will be the margin. This is what you will gain or lose, based on how the markets fair. Online trading platforms usually offer a margin calculator, which you can use to evaluate the position size. Remember, trade only the amount that you can afford to lose.

Include Adequate Risk Management

Never trade without a good risk management strategy in place, regardless of what you are trading and when. One of the best risk management techniques is to put a stop loss order in place. This will automatically close your open position if the market reaches a pre-decided level. With a stop loss order in place, you know that your losses will be limited if the markets move against you. Another order to place is a take profit order, where the open trade will be automatically closed when the price hits a specific level, pre-decided by you, locking in your profit. Make sure you set these levels before you open a trade.

Keep Track of the Market

All financial markets fluctuate, based on various factors, such as geo-political events, economic releases and even market sentiment. Monitor your open positions is the best way to get real-time updates on how you are doing. This could even help you further minimise losses by closing a losing trade as early as possible.

Why Choose CFD Trading

Just like every other type of trading, contracts for difference come with their own advantages and limitations, which you should know before you enter the market.

Benefits of Trading CFDs

  • Ability to trade both rising and falling markets
  • Availability of leverage, which allows position sizes larger than the available capital
  • No hidden commissions or cost of storing a physical or digital asset, which lowers costs
  • Risk is lower than for many other trading instruments.

Limitations of Trading CFDs

  • Availability of leverage can tempt traders to enter into large positions, leading to the potential for large losses in unfavourable markets.
  • Holding an open CFD for the long term could prove to be risky. This is because costs could increase over time beyond what it might have cost you to have actually bought the underlying instrument. CFD positions held overnight entail holding costs.

Is CFD Trading the Right Choice for You?

CFD trading is not for everyone. The first thing you should do is try it out on a demo account and get a feel for it before trading on the live market. CFDs are ideal for:

  • Those looking at short-term trading, since the contracts usually are held for a few days or a few weeks, and not for the long term.
  • Those who are looking to diversify their portfolio, since CFDs are considered a good hedge against other trading instruments.
  • Those who might have varying amounts of time to devote to trading, given that with this type of trading you can give as little or as much time as you wish to.

However, before you start trading, here are some questions you should seek to answer:

  • How much experience do you have of the market in which you wish to trade CFDs? For instance, if you want to trade crypto CFDs, you first need knowledge of the cryptocurrency market and how it works.
  • What are your financial goals and does this form of derivative trading help you achieve those goals, even in part?
  • What is your risk appetite?
  • Do you know how to use leverage to your advantage, so that an unfavourable market doesn't wipe out your account?
  • How much time can you devote to monitoring your positions?
  • Do you have adequate risk management strategies in place?

On the whole, CFDs are a great way to diversify your portfolio, giving you a hedge against bear markets.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks

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