What is a Contract for Difference?
Entering the forex markets as a beginner trader can be quite overwhelming. Aside from the risks and charts that tend to intimidate budding investors, there’s also a whole bunch of FX “lingo” that can be difficult to get the hang of.
Perhaps the first of these “forex-isms” you’ll come across is the term “CFDs”.
But don’t be discouraged by the fancy abbreviation! This acronym is effectively just a 3-letter depiction of the concept of the forex markets. And we’ve simplified it all for you today.
Breaking Down CFDs
A contract for difference, or CFD, is an agreement between a forex broker and trader that allows you to speculate on the price movement of a financial instrument.
In the forex markets, the financial instruments you can speculate on are currencies, commodities, indices, energies, and equities.
As an FX trader, you choose a financial instrument and speculate on whether its value will increase or decrease. In the case of currencies, you speculate on the value of one currency against another.
You then open a trade or “position” accordingly, typically on an MT4 online trading platform.
And just like that, you’ve entered a contract for difference!
This contract means that you and your broker have agreed to exchange the difference between the opening price of the contract and the closing price of the contract, without you ever physically purchasing or acquiring the asset you’re trading.
Let’s Take an Example of a CFD
If you believe the price of gold will go up, you will open a “buy” position, hoping to then sell whatever value of the gold you’ve bought for more money at a later date.
If it goes your way, you can decide to close the “contract” or position at a higher price than what it cost at its opening, meaning you’ve walked away with a profit.
So, CFDs are simply a way for you to monetize and profit from your speculation that the price of gold will go up, without you ever having to physically buy, ship and store a whole load of gold bars.
But remember – the forex markets are risky. If the market moves contrary to your speculative position or trade, you may lose all the money you’ve invested, depending on the closing price of the contract. However, you can always predefine the price at which you wish to close the position, and that’s called the “stop loss” price.
Why Trade CFDs
Before online CFD trading arrived, anyone who wasn’t a financial professional or institution could neither access nor profit from the global forex markets (apart from by physically exchanging money).
CFDs, therefore, enable anyone with an interest in the FX markets to partake in this global industry, no matter where they are in the world.
CFDs are also leveraged products. This means you can invest as little as 1% of the capital needed to yield profits from forex market movements.
In addition, since CFDs monetize your prediction on price movement, you can profit from “short selling”, (or speculating that the price of an asset will go down,) without physically “owning” it to begin with.
So, regardless of how the markets are doing, there is always money to be made and risk to be managed. And you don’t have to have a hefty stash of valuable stock shares to become a forex trader!
What Do I Need to Trade CFDs?
Well, the very basics include a laptop, an internet connection and an account with your forex broker of choice.
However, beyond that, you need to have a good few (hundred!) hours of research and practice on a demo account under your belt before you risk your capital.
These days, we can’t even order a meal without doing extensive research on the restaurant. So investing your money in forex trading should be no different.
Which brings us to another essential: having an allocated amount of money that you are willing to lose. If there’s one thing you’ll quickly learn in the forex market, it’s that it’s volatile and everchanging. So never enter an FX trade with capital you are not prepared to part with.
Now that you know what CFDs are, it’s time for you to learn more about forex trading. And, most importantly, to get practicing on a free MT4 demo account! Luckily, you can do both at Orbex.