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What are forex CFDs and how do they work?

This article gives you insights into what is forex CFD’s and how they work. By the end of this article, you will understand the different concepts used in forex CFD trading. This enables you to have a better grasp of the trading concepts involved when trading the CFD currency markets.

Forex CFDs or contracts for difference is a derivative financial instrument that is also highly leveraged. The CFD instruments draw their price from the underlying asset that they track. The main benefit of using CFDs in forex is that traders can go both long and short on the underlying asset.

Look around and you will find that just about every forex broker offers CFD trading. Although many refer to it as the spot forex market, it is CFD’s that you are trading. These CFD instruments in turn track the prices of the underlying spot forex markets.

CFDs allow traders to speculate on the price movements. Therefore, by taking long or short positions in the forex CFD markets, traders can make a profit. Due to the fact that CFD trading is leveraged, it does not require a huge capital investment.

Since leverage is used, forex CFD’s are risky for the mere fact that a wrong speculative position will wipe out your capital. Hence, risk management is one of the core concepts that traders must follow when trading the currency CFD markets.

CFD’s are available everywhere and includes a variety of financial markets.

In fact, if you visit your forex broker’s website, you will find that they may offer a large range of products to the trade. These can range from precious metals such as gold and silver to commodities like crude oil besides currencies.

All these instruments are available as CFD contracts.

This article gives you insights into what is forex CFD’s and how they work. By the end of this article, you will understand the different concepts used in forex CFD trading.

This enables you to have a better grasp of the trading concepts involved when trading the CFD currency markets.

How forex CFD’s work?

As mentioned earlier, forex CFDs are derived from the underlying spot forex markets.

The spot forex market is where buyers and sellers buy and sell currency pairs. It is an unregulated, over-the-counter market. Hence, unlike stocks, the currency markets are not settled at an exchange. On the contrary, forex deals are settled bilaterally.

Most of the transactions in the currency markets take place via the interbank market. This is where banks and large institutions execute orders.

To understand how forex CFD’s work, one should understand how the underlying spot forex market works.

How does the spot forex market work?

The spot forex market is where one would buy and sell one currency for another. This is commonly referred to as the forex currency pair.

The price you see in the forex market is the exchange rate of the two currencies in question.

In the spot forex market, the transaction is settled as cash. This cash delivery takes place two days after the deal is agreed upon. In trading terms, it is referred to as the settlement day, which is T+2.

But as you may notice, when it comes to forex CFD’s, there is no physical transfer of cash. The amount is merely credited or debited to your forex trading account.

This depends on whether your speculative position closed in the profit or with a loss.

When participants in the interbank markets engage in forex deals, the prices are published. Banks often publish the price at which they will buy or sell the currencies.

This is commonly known as the bid and ask price.

The bid price is the price at which the bank is willing to buy and the ask or offer is the price at which they are willing to sell.

Hence, when another participant wants to buy or sell, they can buy at the ask price and sell at the bid price.

In a spot forex transaction, the deal is based on the prevailing market price. Once the deal is confirmed, the settlement takes place two days later.

In forex CFD trading, traders don’t have to worry about the physical delivery of the underlying. Only the difference in the price is settled.

Unlike the spot forex markets where the transaction is completed in full, forex CFD trading is enabled via margin or leverage.

How does margin or leverage work with forex CFDs?

CFD trading is leveraged. This is something you may have heard about many times. But do you really know what it means to trade with a leveraged financial instrument?

Leverage is simply the ability to control larger financial positions without having to put up the full amount upfront.

For example, if you want to buy one lot in EURUSD, it is equivalent to $100,000.

This is an amount that not many retail traders have. To control the $100,000 position, forex CFD allows the use of leverage. The leverage is the amount borrowed from your forex broker. Instead of having to put up the entire amount, you can only put up a margin or a fraction of this amount.

Thus, a trader with $1000, can easily control or open a position worth $100,000.

In this instance, the leverage that is being used is 1:100. This means that for every dollar that you put up, the broker puts up $100.

Leverage is important in forex because without it, you will need to have a large capital to trade. This is something that many retail traders simply don’t have.

By using leverage, traders are then able to make a profit from the price movements. Using the long or short positions, CFDs allow you to speculate in the direction of the price movement in both ways.

Leverage is very useful when trading the currency CFD market. But improper use of this can lead to leverage wiping out your initial capital.

This is why many regulators have implemented market regulations that limit how much leverage a trader can choose.

What are the financing costs of trading forex CFDs?

While forex CFDs may be speculative instruments, there are financing costs involved as well. No matter whether you go long or short on a currency pair, there are fees involved. This is true if you keep your position open overnight.

These costs of financing are based on the annual interest rate difference between the currency pairs. This is then converted to the base currency. These overnight financing costs are then debited or credited to your trading account at the close of markets every day.

In trading terminology, these financing costs are referred to as swap long and swap short.

The swap fees are applied to any open positions you may have toward the end of the trading day. They are sometimes referred to as rollover fees.

These fees are in place to ensure that there are no arbitrage opportunities in the market and to make it a fair game for all participants.

Can you make money trading forex CFDs?

Yes, you can certainly make money trading forex CFDs.

When you open a position in the forex markets, you are essentially buying one currency and selling the other. This is known as going long in the market. Likewise, when you are selling one currency and buying the other, it is known as going short in the market.

A trader has a long position in the market when they expect one currency (the base currency) to appreciate in value against the other currency (the quote currency). Similarly, a trader takes a short position when they expect the base currency to depreciate in value against the quote currency.

With a forex CFD contract, when you are long and the price rises, you make the money by the difference in the prices. This difference, which is a profit, is then debited to your trading account. But if you were wrong and the price falls, then the loss is credited from your trading account.

Thus, by speculating the direction of the markets, one can make a profit (or lose) when trading the forex CFD markets. And since leverage is involved, traders should be careful of how much trading capital they risk on every trade.

CFD forex trading example

By now you have a good understanding of forex CFD and how they are different from the spot forex markets.

Let’s build up this to get a better idea by taking a forex CFD trading example.

Long position EURUSD Forex CFD

In case of a long position, you would want to take this position when you think that the euro will appreciate, relative to the US dollar.

Let’s say that the EURUSD current price is at 1.1800. You think that the price will rise during the course of the day, and you place a long position at 1.1800.

After a few hours, the EURUSD exchange rate is at 1.1810. This is a 10 pip move. Assuming that you traded one standard lot on leverage, this equates to $100 in profit.

On the other hand, if the EURUSD exchange rate fell to 1.1790, this would mean a loss of $100.

Short position EURUSD Forex CFD

In the case of a short position example, a trader thinks that the currency pair will fall. Thus, in the example of a EURUSD, you will take a short position if you think that the euro exchange rate will depreciate against the US dollar.

If you went short at 1.1800 and the exchange rate for the EURUSD is at 1.1790, then this 10 pip movement will create a profit of $100 (assuming that you are trading one standard lot).

But if the price rose to 1.1810, then these 10 pips move in the opposite direction to your trade will cause a $100 loss.

When trading forex CFDs, traders make use of stop loss and take profit. These are limit orders that are triggered when the price reaches a specified price point. A stop loss is an order that limits your loss on a trade.

A take profit is also a limit order which is executed when the market price reaches the specified take profit price you use.

Forex CFD’s frequently asked questions

Can I exchange currencies using forex CFDs?

No! Forex CFDs are purely speculative instruments. Traders use forex CFDs for hedging against the underlying market. Hence, when you buy or sell a forex CFD instrument, the price difference is settled. There is no actual exchange of the underlying currencies.

Are forex CFDs same as options?

CFDs and options are two completely different financial instruments. While they are both derivative instruments, the way they work is completely different. While forex options allow you to trade with much lower capital, you can lose money.

Forex CFDs on the other hand require you to either day trade or buy and hold a position in a forex CFD currency pair for a certain period of time.

Can I trade directly in the spot forex markets?

Trading in the direct spot forex markets is typically out of reach for the average person. This market is dominated only by large banks and other financial instruments. Hence, the average retail trader simply does not have enough money to trade directly in the spot forex markets.

However, if you have ever exchange currency at an airport or exchange currency at a bank, that is nothing, but the retail version of the spot forex markets.

Can the forex broker make money when you lose, trading forex CFDs?

This depends on how the forex orders are executed. If your forex broker operates a dealing desk, then chances are that the forex broker is your counterparty.

In this case, the forex broker may make money when you lose and vice versa. However, forex brokers do not act as counterparties all the time. They can hedge out their positions against other traders to limit their risk.

Forex brokers that operate no dealing desk pass your orders into their liquidity pool. This enables them to charge a commission or a fee for their service. In this instance, the orders are matched by other traders in the liquidity pool.

Does the forex CFD prices reflect the actual interbank prices?

Forex CFD prices broadly represent the actual spot market prices. But depending on the forex broker, a mark upon the bid and ask prices can make the exchange rates slightly different. This is true even when you go to your high street bank.

The bank will also add a mark upon the bid and ask prices if you want to convert your money to another currency. But overall, the prices don’t deviate much from the interbank markets. So to answer the question, forex CFDs do not reflect the interbank prices accurately, but they are somewhat close.

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Disclaimer

The information provided is of a general nature and is not intended to be personalised financial advice. The information provided is not intended to be a substitute for professional advice. You may seek appropriate personalised financial advice from a qualified professional to suit your individual circumstances.

Trading in Rockfort Markets derivative products may not be suitable for everyone as derivative products may be considered as high risk. Please ensure that you understand the risks involved. A Product Disclosure Statement can be obtained here and should be considered before trading with us.

William B

August 10, 2021

  • Reading time: 7 mins
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