If you’re looking to expand and diverse your investment portfolio, it may be worth considering contracts for difference (CFDs). These financial derivatives can be used to trade a variety of securities, such as stocks and commodities, but in this article, we will focus on how to trade foreign exchange (forex) CFDs.
The first point of call, is to understand what are CFDs. According to the Plus500 forex trading platform, a contract for difference is:
“a form of trading that allows you to speculate on the price movements of different asset types, like currency pairs, shares [or] commodities… Rather than settling the underlying asset, you are trading on the price movement of the underlying asset.”
Forex CFDs, therefore, allow investors to speculate on the price movement of the underlying currency pairs, without having to own the actual currency. The investor and the issuer in the transaction enter into the contract, with the agreement that any profits or losses are determined by the difference between the opening and closing prices of the contract. In this case, this refers to the value of the base currency in relation to the quote currency.
Understanding currency pairs
In relation to forex CFDs, as well as understanding how to trade the contracts, you should also understand the underlying market and how a currency pair works, before entering the market in any capacity. This is because CFDs are an alternative way to trade currency pairs, so it comes as no surprise that you should know how they work.
As aforementioned, forex trading consists of two currencies that form a pair. These are known as the base currency and the quote currency, with the exchange rate reflective on the quote currency. Effectively this is comparing one economy against the other.
In the example of the Euro and US Dollar currency pair (EUR/USD), it is likening how the US economy is faring against Europe. In this case you would be buying in Euros and selling in Dollars, and should the Euro strengthen against the Dollar, then you’d have the potential to profit. However, if it should fall against the USD, then you would incur a loss. Therefore, a further understanding of political and economic factors that impact the nations’ currency, is detrimental to trading forex CFDs.
Deciding your trading position
Once you have a grasp on the forex market, you will then have to decide on what position you will take in relation to the CFDs. This essentially means whether to go long or go short. If you predict that the price will rise, then you will buy (going long) and if you believe that it will fall, then you would sell (going short). The benefit of trading forex CFDs is that you can speculate on both a rising or falling market.
When trading CFDs, you also need to be aware of the different prices involved, relative to the underlying forex pair. You’ll be presented with the sell price, known as the bid, which is the quoted price to enter the contract. This is slightly different to the actually price you buy the contract, which is known as the offer, and so causes discrepancy in price, called the spread.
In contrast to traditional forex trading and market opening times, CFDs can be closed at any time in reaction to price fluctuations. In most cases, CFDs can be used as part of a short-term strategy, and not necessarily held for long periods of time.
Another beneficial factor of trading in forex CFDs, is the use of leverage. This enables you to have larger exposure to the forex market, but only committing a smaller amount of capital. Although this can lead to magnified potential profits, it can also result in higher losses, so is another thing to take into consideration when forex trading with CFDs.
If using a reputable and reliable CFD trading platform, there will be risk management tools available to help control your forex trades, as well as a range of technical analysis tools and data, to aid you in making well-informed trading decisions.