Сontracts for difference (CFDs) are derivatives, along with futures, options, swaps, forwards, and others. These are trading products whose value derives from the assets at their core, called underlying assets – indices, shares, commodities, cryptos and Forex pairs.
Forex CFD trading enables to profit from the ups and downs of the fast-moving Forex market without owning any of the assets in the first place. Traders don’t buy or sell the underlying currencies, but speculate on whether the value of one currency will rise or fall against the other.
Let’s add some numbers to the example. The EUR/USD is trading at 1.16340/1.16350 (bid/ask). You believe that the pair will be volatile and euro will go up against the US dollar, so you buy 100 Forex CFDs at 1.16350.
After a while the EUR/USD grows by 30 pips, and the new quote is 1.16370/1.16380 (bid/ask). You decide to close your position buy selling 100 CFDs on EUR/USD at 1.16370.
You bought at 1.16350 and sold at 1.16370. The 20-pip difference is your profit. Given the fact that you have purchased 100 CFDs, you earn 100 x 20 = $2,000.
Yet, if the market takes the opposite direction, you will incur a loss of $2,000.
Trading CFDs on Forex: benefits
A contract for difference is a leveraged product. This means that to trade an FX CFD, you need to deposit only a particular percentage of the full trade value, called the initial margin. Your funds are then magnified, or leveraged, and you receive a greater exposure than you could afford.
Your profit is calculated based on the full value of a CFD position. So with a relatively small initial deposit you can expect quite a generous return, however, your losses are exposed to this magnifying effect as well.
Forex CFDs amplify trading opportunities because they enable you to make a profit on the markets that go down.
A CFD is an agreement to exchange the price difference at the beginning of the contract and at the end of the contract. If you believe that a Forex instrument is going to drop in value, use the ‘Sell’ option in the Capital.com platform. If your predictions end up right, you’ll close the position by buying back the underlying asset. The price difference will be your profit.
Foreign exchange trading via CFDs can be a useful method of hedging or protecting your investment portfolio from the risk of adverse price movements.
Trading CFDs on Forex: risks and costs
We’ve already explored the magnifying effect that it produces on profits. However, leverage is a double-edged sword, exponentially increasing both your profits and losses.
Should a pessimistic scenario occur, a trader who uses leverage loses more that he would without leverage.
When trading CFDs you have to pay a spread, or the difference between the buying (higher) and selling (lower) price.
For example, AUD/CAD is quoted at 0.9718/0.9721. The difference between the two values – 3 pips – will be the spread for the currency pair.
If you speculate on products with spreads, for trades to profitable the underlying assets have to move in price beyond the spread value. The smaller the spread, the less the currency needs to move in your favour before you begin to reap profits.
CFD Forex trading: who is it is suitable for?
Trading in CFDs will not be appropriate for all traders. First, it suits those who seek short-term exposure to Forex markets with an aim to speculate on them or hedge portfolio risks. In order to trade in FX CFDs, investors should be familiar with the concept of leverage and have experience of margin trading. The risks associated with derivatives are too high and can withstand the loss of the entire invested capital. Thus, CFD traders need to have sufficient funds and be aware of the risk/reward ratio as compared to traditional foreign exchange trading.
ESMA leverage limits for CFDs on Forex
On 27 March 2018, the European Securities and Markets Authority, or ESMA, agreed on product intervention measures related to the provision of CFDs. The financial regulator introduced new CFD leverage limits for retail clients, which are based on the volatility of the underlying asset.
The following leverage restrictions have been introduced for Forex markets:
1:30 for major currency pairs
1:20 for non-major currency pairs
In our blog you can find additional information on ESMA’s measures concerning contracts for difference, and how Capital.com complies with them.