How Are CFDs and Forex Similar and How Are They Different?
Why Trade CFDs?
CFDs and Forex: The Similarities
Contracts for difference (CFDs) and forex actually have a lot in common, which leads many investors to trade in both. The similarities are significant:
- Trading never stops and is always taking place somewhere around the world and around the clock
- Trading is always taking place irrespective if the respective market is perceived to be strong or weak, rising or falling
- Both are traded in the over-the-counter (OTC) market
- Since trading is conducted electronically over a banking network, it therefore does not require the presence of a trader at any specific physical location or a central exchange
- As opposed to other types of investments that entail commissions and other fees, the only trading cost involved with CFDs and forex is the spread
The simplicity of CFD and forex trading, moreover, is underscored by the fact that the investor does not actually have to obtain legal ownership of any underlying asset. This eliminates paperwork, bureaucracy and, perhaps most importantly, time, which is always of the essence in speculating. So when you “buy” euros and “sell” dollars (or any other currency set) in a forex trade, you’re not really purchasing them. You’re simply speculating on the direction the exchange rate between them will take over a specific period of time. Similarly, when you “buy” a CFD contract on an exchange, you don’t actually own the stocks or commodities involved. You’re speculating on their underlying price. Because of this parallel, forex is considered another kind of CFD.
The trading period for both CFDs and forex can be as short as one hour or as long as a week or more, and is determined by the trader at the start. In this way, he or she designs the trade in tandem with his or her own trading goals.
CDS and Forex: The Differences
The main difference between CFDs and forex is that the former involves different types of contracts covering a diverse set of markets, such as stock indices, energy, and metals, while forex (a portmanteau formed from the words “foreign” and “exchange”) is, as its name suggests, limited to currency.
When you trade CFDs, you have the opportunity to select different contracts that will vary due to their market value and the currency to which they are pegged. Those factors very much depend on relevant economic indicators in the country in which the underlying assets originate and the country that obtains them. These tend to be microeconomic. Among them, of course, are supply and demand, as well as various commercial issues that directly affect importers and exporters, such as the anticipated signing of new contracts, revenue, mergers and acquisitions, and newly-enacted government regulations.
Forex, in contrast, pits one currency against another and always requires trading in uniform lot sizes. What that means is that when you make a forex trade, X amount of one currency equals Y amount of the other. What you’re predicting is how much X will be worth in comparison to Y at the end of the trading period. This relationship between X and Y is mainly determined by macroeconomics, including the balance of trade between countries that use X or Y to pay for their imports and receive X or Y in exchange for their exports, comparative inflation and interest rates and key indicators such as GNP and GDP. It can also be affected by other factors such as election results, changes in tax or trade policy and, of course, traumatic global events such as armed conflict, the threat of armed conflict and natural disasters.
Another major difference is that CFD traders can theoretically hedge against losses by applying their own stop losses, although they can do so only when losses are imminent. Forex traders cannot do so.
In comparing CFDs with forex, keep in mind that the foreign currency market is the most widely traded in the world. That’s not only a result of demand. Estimates are that trillions of dollars in as many as 120 different currencies are traded on a daily basis. That’s a mind-boggling amount. Nonetheless, it’s relatively easy to understand and track, given that the forex market is dominated by just a few currencies. That’s a big draw for both new and veteran investors alike.