What are CFDs in forex? Quick and Easy Guide

CFDs trading is an exciting segment of the derivatives market where traders can realize good margins through speculation if they understand market movements. This brief and easy guide explores this market segment with a view of helping experienced forex traders looking to getting into it.

What Exactly Are CFDs? For Forex Traders

CFD stands for contracts for difference, a term that may confuse forex purists who only trade currency pairs. CFDs, as you may guess from the term contract involve entering into speculative contracts or purchasing speculative contracts with a CFD provider on an underlying asset or security or tradable asset.

The key point to note about is that the contract signed based on the price change of an underlying asset which could be anything but, in this context, the item whose price change is being speculated upon is currency or forex. CFD trading is usually categorized under the derivatives market but some people may say they are trading futures. CFDs, in essence are just another financial instrument available in secondary markets.

When you enter into a CFD contract with a provider, you are agreeing to pay or be paid an amount of money based on the price change of the underlying asset. This means you don’t hold or purchase the underlying asset nor do you care what its value is at the beginning and end of the contract. You the buyer and seller exchange

Here is a simplified version of a typical contract for futures transaction or trade involving forex:

  • Select a currency pair you want to speculate on or bet on its price movement
  • Buy a CFD contract units from a spread betting firm or broker with a quoted buy price for the currency pair. Note that most CFD traders use online trading accounts and don’t need to select specific CFD sellers or provider
  • As soon as the underlying currency pair price starts moving in your favor you will start making multiples of profit depending on the number of units you purchased. If the price moves in the opposite direction you pay the spread and make a loss which is usually deducted from your trading account

CFD trading is a relatively new and rapidly growing market segment that has gained so much popularity where it is allowed. Trades are usually carried out quickly and gains can be realized within short periods depending on the terms of the CFD. This makes it an attractive trading strategy for short term forex traders who are willing to risk their capital for quick through pure speculation.

You get paid or make a profit in CFD trading when you are able to read the price movements of the underlying assets well.  This requires a lot experience and sometimes luck to get right but the rewards are usually quite attractive and come fats. CFDs also usually have a time limit so you have limited time in which the underlying asset’s price must move up or down depending on your prediction.

For instance, if you can predict that the price of the underlying asset will rise in future then you can purchase a CFD with that price with specific time limits as stipulated in the contract. If you are right and the price of the CFD does rise within the contract timeframe, then you can sell your CFD and your gains will be calculated and deposited your account

How Does Forex CFD Work?

Contracts for difference can be based on the price movement of almost any tradable security or asset which includes stocks, commodities, and even forex currency. In the case of forex, you will be placing bet or making predictions based on the price movement of a currency pair. This is different from traditional forex trading where you trading on the value of currency pairs directly and you are not purchasing any contracts.

There is no buyer and seller in traditional forex trading whereas you need a CFD provider, spread betting firm or a broker who acts as a seller to enter to contracts for futures trading. In most cases, the providers or CFD brokers themselves may be investing on underlying asset themselves or deal purely with derivatives.

Some regulators in certain countries restrict or ban CFD trading because players don’t necessarily have to comply to secondary market policies since they don’t deal with securities directly. You should therefore check that you are allowed to get into CFD trading in your country even if you are using a foreign trading account. Some countries don’t have specific laws touching on CFDs.