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Forex CFDs: Overview, How it Works, and How to Trade

TABLE OF CONTENTS

Forex CFDs: Overview, How it Works, and How to Trade

Forex CFDs: Overview, How it Works, and How to Trade

Vantage By Ian Updated Updated Mon, 2022 May 9 02:57

Forex CFDs are one of the most common trading tools you’ll find on your CFD trading platform. In this guide, we go through what Forex CFDs are, how they work and how you can trade them.

Key Points

  • Forex CFDs (Contracts for Difference) are financial derivatives that enable investors to speculate on the price movements of currency pairs in the foreign exchange market without owning the actual currencies.
  • Forex CFDs work by mirroring the price fluctuations of currency pairs, allowing traders to make a return from the difference between the opening and closing prices without the need to physically exchange currencies.
  • Forex CFDs provide an easy access to the foreign exchange market, the ability to go long or short and the flexibility to trade on margin.

What are CFDs in Forex?

Forex Contracts for Difference (CFDs) are financial tools that allow you to speculate on the price movements of currency pairs. Forex CFDs work similarly to other CFDs, except with currency pairs. 

Since the forex market is volatile, you can opt to trade forex CFDs as a trader and take advantage by speculating on both rising and falling prices. Unlike other instruments, forex CFDs give you the opportunity to take advantage of market opportunities whether the markets are on an upward or downward trend.

Before you venture into forex CFDs, you need to understand how the underlying forex market works. Let’s look at some vital elements of forex CFDs below:

1. Currency Pairs

Foreign exchange trades happen in currency pairs. That way, you’re buying one currency of the pair while simultaneously selling the other. [1]

Take the GBP/USD pair as an example. You have the base currency on the left, which is the GBP. This base currency is also what you’re buying. You have the quote currency USD on the right, which is what you’re selling. 

So, if the GBP/USD pair trades at 1.4400, that means it takes USD1.44 to buy 1.0 GBP. If the price of this pair moves up to 1.4800, that now means you’ll have to pay more US dollars (at USD1.48) to buy 1.0 GBP.

2. Lots

To standardise the forex market, currency pairs trade in lots. Lots, in essence, are batches of currency. Since price changes in currency markets are often small, lots have to be significant to take full advantage of these movements.

In forex, a standard lot is 100,000 units. Of course, you can trade in fractional lots. Most brokers offer mini (10,000 units), micro (1000 units), and nano (100 units) lots.

3. Margin

In CFD forex trading, margin refers to the amount of money that a trader needs to have in their account to open and maintain a position. It acts as a deposit to cover any potential losses that may occur during trading. Margin requirements vary depending on the broker and the currency pair being traded. 

4. Pip

A pip, short for “percentage in point”, is a unit of measurement used to express changes in the value of a currency pair. It’s the smallest amount by which the value of a currency pair can change, and it’s usually the fourth decimal place of the exchange rate. For example, if the exchange rate for EUR/USD changes from 1.2500 to 1.2505, this is a movement of 5 pips. 

By learning about pips and how to calculate them, you can become a more well-rounded trader. To gain a better understanding of this term and its significance, check out our guide on pip calculation here.

5. Bid-ask spread

The bid-ask spread is the difference between the highest price a buyer is willing to pay (the bid price) and the lowest price a seller is willing to accept (the ask price) for a particular currency pair. It’s the cost of trading and represents the profit that a broker earns on a transaction. A narrower spread indicates a more liquid market and lower transaction costs, while a wider spread indicates a less liquid market and higher transaction costs. 

Difference Between CFD and Forex 

Forex trading is different from CFD trading. There are some fundamental differences between these two instruments:

  • Forex trading is limited to currencies, while CFD trading covers more types of assets. For example, you can trade commodities, indices, futures and even stocks using CFDs.
  • Regardless of the currency pairs, you choose to trade, lot sizes are uniform in all forex markets. For CFDs, however, you can trade a wide range of contract sizes across different asset classes.
  • Although spread is the primary way you pay trading costs in both forex and CFDs, you may pay other charges on your CFDs. For example, holding a CFD position overnight may attract a financing cost, and in some cases, you may pay commissions.

If you’re interested in learning more about the differences between CFD and Forex trading, head over to Academy and read our guide on this topic.  

Type of Forex CFD 

Here are the four different types of Forex CFDs: 

1. Spot Forex CFDs

Spot forex CFDs are traded based on their real-time current market price, with no fixed expiration. Traders can buy or sell these contracts at any time. 

2. Options Forex CFDs

Options forex CFDs grant traders the right, without obligation, to buy or sell a currency pair at a predetermined price, even if the market price moves beyond that level within a specified timeframe. 

3. Forward Forex CFDs

Forward forex CFDs are contracts that enable traders to buy or sell a specific amount of a currency pair at a predetermined price on a set future date. 

4. Swap Forex CFDs

Swap forex CFDs involve exchanging one currency for another at a predetermined rate on a specific date. This exchange can be reversed at a later date using another predetermined rate. 

How Forex CFDs Work

Forex CFDs work similarly to CFDs in other asset classes. It also comes with all the features, benefits, and risks of different CFD types. For example, you can still take advantage of market opportunities in a bull or bear market using CFDs, as long as your price predictions are accurate.

Let’s look at some features present in Forex CFD markets.

1. Leverage in Forex CFDs

Forex CFDs are leveraged, which means you can increase your exposure in the forex exchange market without having to pay the full price of the asset from the start.

Say, for instance, that you’d like to trade the USD/GBP forex pair.

You may have to purchase an entire lot, which is 100,000 units. Most traders don’t have enough capital to buy a lot. However, with a forex CFD, you can put up just 5% of the cost (or less, depending on your broker) to control a position the size of one lot.

Using leverage in Forex CFDs can present both massive opportunity and risk. Your profit and loss are still calculated on the full size of your position. While you can make huge profits trading CFDs, you can also make huge losses that exceed your capital.

2. Margin in Forex CFDs

You require a minimum amount of capital in your account to open a forex CFD position. This minimum amount is called margin. There are two types of margin:

  • Deposit margin
  • Maintenance margin

A deposit margin is pretty straightforward. That’s the amount you need to open a leveraged CFD position in the forex markets.

Maintenance margin is what you need to keep your forex CFD positions open. If your trade gets close to incurring losses that your deposit margin or any other extra funds in your account cannot cover, then the maintenance margin keeps your positions open.

Without maintenance margin, once you get close to incurring losses, your broker may stop you out of your positions and give you a margin call –a request to add more funds to your trading account.[2]

3. Hedging in Forex CFDs

More sophisticated traders can use Forex CFDs to hedge their positions. Hedging involves holding two (or more) positions on one asset simultaneously to offset any losses from one position with potential profits from the others.[3]

4. Fees in Forex CFD

To trade Forex CFDs, you’ll have to pay some costs and fees. Let’s take a quick look at them:

  • Spread is the difference between buying and selling prices on the forex pair. Every Forex CFD trade you make pays a spread. You can consider opting for currency pairs with narrower spreads because any slight movement in favour of your predictions means you can take advantage of market opportunities.[4]
  • Depending on your broker or jurisdiction, you may also pay Commissions when you trade some forex CFDs.
  • To access additional data to help with your trading, you may pay market data fees that keep you up to date on your favourite currency pairs.
  • You may have to pay your broker holding charges to maintain your position open overnight. These fees may be positive or negative, depending on how your open trades go.

How to Trade Forex CFDs

If you want to start trading Forex CFDs today, here are some quick steps to get started.

1. Open and fund your trading account
2. Develop a trading strategy
3. Choose your currency pair
4. Open your first forex CFD position
5. Monitor and close it

Create and Fund Your Trading Account

Setting up a trading account for your Forex CFDs can be done in a few steps. Choose a broker and follow the steps to open an account on their website. Once you’ve added verification details like your ID and proof of address, you’ll get instant access to the forex markets, once your account is approved.

To begin trading, connect your credit/debit card/bank account to your trading account to fund it. Most brokers have promotions, bonuses, and deals for new accounts as per the applicable legislation. Take advantage of them to get started on your trading journey with a boost to your new trading account.

Vantage, for instance, offers a promotion where traders who opt-in before funding their initial deposit into their trading account for the first time can receive a 50% deposit bonus. To learn more about this promotion, visit the Vantage website here

Develop a Trading Strategy

A trading strategy is how you manage your risk and plan how to use your capital to make trades. It also helps you determine acceptable losses and profits. Ensure you use fundamental and technical strategies to analyse your chosen forex pair before getting into a CFD position. [5]

Want to learn more trading strategies? Read our top 11 forex trading strategies article in our academy.

Choose Your Currency Pair

Choose your currency pair based on your strategy. You can also choose currency pairs on either spot CFD markets or forex options markets. You can start with a single pair or trade several currency pairs simultaneously.

Some popular currency pairs you can pick from include:

  • EUR/USD (euro/US dollar)
  • USD/CNY (US dollar/Chinese Yuan)
  • USD/CHF (US dollar/Swiss franc)
  • AUD/USD (Australian dollar/US dollar)

Open Your First Forex CFD Position

Open your first forex CFD position by buying or selling your chosen currency pairs from your trading platform. Buy the pair if you expect the base currency to rise in value or sell the base currency if you expect the value of the quote currency to rise.

You may consider placing stops and limits on all your open positions. Stop losses and limits are essential tools in managing risk and reducing exposure.

Monitor Your First Position and Close It

You can now monitor your open positions on your trading platform. Some platforms send you trading alerts as push notifications, emails, or via SMS.

Final Thoughts

Forex CFDs are an excellent way to take advantage of market opportunities from the forex markets without buying the underlying currencies. 

Why not start trading forex CFDs with Vantage? You can practice trading with virtual credit using the demo account. Additionally, you can trade CFDs for other products such as commoditiesshares, and ETFs with Vantage. 

References

  1. “What Is Forex Trading? Guide to Foreign Exchanges – Investopedia.” https://www.investopedia.com/articles/forex/11/why-trade-forex.asp. Accessed 7 Apr. 2022.
  2. “Margin Call Definition – Investopedia.” https://www.investopedia.com/terms/m/margincall.asp. Accessed 7 Apr. 2022.
  3. “What Is Hedging as It Relates to Forex Trading? – Investopedia.” https://www.investopedia.com/ask/answers/forex/forex-hedge-and-currency-hedging-strategy.asp. Accessed 7 Apr. 2022.
  4. “Spread Definition – Investopedia.” https://www.investopedia.com/terms/s/spread.asp. Accessed 7 Apr. 2022.
  5. “Forex Trading Strategy Definition – Investopedia.” https://www.investopedia.com/terms/forex/f/forex-trading-strategies.asp. Accessed 7 Apr. 2022.
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