If you look carefully at the websites of forex brokers, you will often come across the term CFD (or CFDs). This stands for ‘Contract (s) For Difference’. These contracts are often used to open and close your forex positions. What does that mean exactly? What are the consequences for you as a forex trader? And what else can you do with CFDs? You can read it in this article.
What is a CFD?
A contract for difference (CFD) is a derivative financial product. That is, its value is based on the value of another product. Compare it with an option. A (call) option gives you the right to buy a share at a certain price. The value of the option is based on the share price. If the share price is 50 euros, and the option gives you the right to buy that share for 40 euros, then the option is worth 10 euros.
In the same way, the value of a CFD is based on the value of another product. A CFD requires the buyer and seller of the contract to settle the price difference of another product (for example, a share) in the future. Let us explain this:
The buyer and the seller are usually the trader and the broker, but it can also be two traders who are linked together via a broker.
They agree with each other to compare the price of a product in the future with the current price.
That other product is, for example, a stock, or a commodity, or a forex pair.
The seller pays the buyer the price difference if the price has changed in his favor; if the price has changed to his disadvantage, the buyer pays the seller; they settle the price difference with each other.
If a (long) contract on a share is opened at a price of 50 euros, and a week later the price is 60 euros, then the seller of the CFD must pay 10 euros to the buyer. The contract is therefore worth 10 euros at that time.
As you can see, the value of a CFD precisely follows the gain or loss on the stock price. But there is an important difference: you need 50 euros to buy the stock; to buy the CFD you only need a small amount of margin (usually 3-10% of the value) to cover possible losses. As a result, you can trade with CFDs for much larger amounts than if you buy shares on the stock exchange.
Spot forex, futures and CFDs
If we look at forex, there are (in theory) different ways to trade in currency pairs:
Spot Forex: the direct exchange of currencies at the current exchange rate. For example, you can go long on the Euro against the US Dollar by exchanging $ 10,000 for € 8,500 (if the EUR / USD rate is 1.1765). For that you first need $ 10,000. The euros are yours immediately. You ‘close’ your long position again later by selling your € 8,500 for the number of dollars it is worth at that time.
Forex futures: you conclude a contract to, for example, sell $ 10,000 in US dollars at a fixed price in the future at a predetermined price. You only have to pay on the date that the contract expires, and then the euros are yours. Whether the price you pay is favorable or unfavorable depends on how the dollar rate develops in the meantime. On the expiration date you need $ 10,000 for the transaction, but before that time you only need to enter a margin as a guarantee that you will meet your obligation. You can also resell the futures contract to someone else before it expires, leaving you with only your profit or loss.
Forex CFDs: the contract you conclude is only to settle the exchange rate difference between now and the future. For example, you put a margin of € 284 (one thirtieth) to go long for $ 10,000 on the EUR / USD at a rate of 1.1765. The contract has no fixed end date. If you end the position again two days later at a rate of 1.1905, you will receive the profit of € 100 in your account. The euros were never yours, and you never had to pay $ 10,000.
In practice, spot forex trading for individuals does not actually occur. The reason is simple: it is impractical to own many tens of thousands of euros in foreign currencies and to move back and forth. This is only done by banks, governments, and large companies that trade abroad. The only form of spot forex trading that you are likely to encounter is at the border exchange office when you go on holiday.
There are some big brokers where you can trade in fx futures. These are mainly used by institutional investors, and are often not very user-friendly. The minimum stake is usually € 10,000 or more, and the smallest position in which you can trade in 1 lot (100,000 units). Moreover, you must pay careful attention to the expiry date of your futures contracts, because if you do not sell a contract on time, you will receive the base currency of the contract !!!
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With almost all brokers that focus on private traders, you trade in CFDs on forex. This means that you can trade in large positions with a small margin; that you will never actually receive the currencies on which you go long or short; and that only the gains and losses are settled with you. Examples of these brokers are Markets.com and Plus500.
CFDs on other products
Contracts for difference can in principle be concluded on every conceivable financial product. There are therefore not only CFDs on currency pairs, but also on stocks, stock market indices, commodities, and cryptocurrencies. In all these cases, CFDs work the same: the price follows that of another product, but you only have to enter the margin. When you close the position you only settle the price difference; you will never receive shares, gold bars, or barrels of oil. You can trade both in forex and on many other stock exchanges from one trading platform.
Many brokers choose to offer CFDs that are not based directly on the underlying product, but on futures contracts. So that is a derivative of a derivative. The reason for this is that futures contracts are traded on the stock exchange, and that the value thereof is easy to determine. It can be argued what the ‘market price’ of cotton is at a certain moment, but the price of a cotton futures contract that expires on 31 March is undeniable.
Every advantage has its disadvantage, and with these futures contracts the disadvantage is that they expire on a certain date. Many CFD brokers resolve that by approaching the expiration date by rolling the contract to the next futures contract on the same underlying value. Because the old futures contract is then terminated, and the new contract is opened, the price difference is settled at that time. That can cost you money (in the event of a loss) or yield money (in the case of a profit). These are the so-called rollover rates.
This ‘rolling through’ of contracts only happens with CFDs that are based on futures contracts. For forex CFDs based on cash currencies, the rollover rate is the difference in interest rates on the base currency and the quote currency. Again this can cost you money or yield you money, depending on the currency pair you have purchased.
If you want to trade in currencies as a private investor, you will in fact always end up with a CFD broker. This means that you do not actually have to own the currencies in which you trade, but that you only have to settle the exchange rate difference on your positions. You need a small capital as a margin, and with that you can trade in much larger amounts.
From the same platform with which you trade in forex, you can also trade CFDs on other products with most brokers: for example, shares, commodities or stock market indices. This is useful if you want to keep your investments well organized. If you keep your CFDs for longer than a few days, you must take into account the rollover rates, which can save you money or costs.
You can see Spot fx trading mainly at the exchange office
By S.van der Tap Pd.Internet Marketer Founder Of digitalstico.com
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