Contract for differences (CFD) and forex are both ways to trade on the Forex market, but how they work is different. For example, you cannot use CFDs in the same way that you use forex when trading. Crucially, there are also key differences between what types of investors would be suited to each type of product.
This article explains how CFDs work and also highlights the key differences between CFDs and Forex, so that you can make a better decision about which to trade in order to achieve your aims.
What is a contract for difference?
A contract for difference (CFD) is an agreement to exchange the difference in the value of underlying security. In other words, it’s when you bet on whether security will go up or down in value. With a CFD, you do not buy or sell the actual asset – you simply make money off the movement of that asset. If this sounds confusing, read on!
Imagine that there are 2 people who have decided to invest $1000 into Dell computers each (we’ll call them ‘Alice’ and ‘Bob’). Alice decides to place her $1000 dollars directly into Dell’s stock, whereas Bob chooses to play it safe by buying a CFD.
Here is an example of what happens:
By the end of the year, Dell has made more money than expected thanks to booming demand for its products, and so its value has risen by 40%. This means that Alice is now $400 richer – she owns 4% of the company outright, and so her investment has increased in value.
Bob isn’t quite as lucky. He didn’t actually own any Dell stock; he just bet on its price moving up or down. The trouble is, the shares did rise (just not by as much as he had hoped), so Bob is actually $400 poorer.
But there’s more! Here is what would have happened if the two different investments had gone down in value:
The same thing happens to Alice – her investment decreased in value, and now she is only worth $600. However, Bob managed to avoid losses because of his CFD – he made a loss of only $100.
What is the key difference between CFDs and forex?
The main difference between CFDs and trading forex is that with a contract for difference, you are betting on whether the security’s price will increase or decrease (rather than buying it outright).
In this example, if Dell’s share price had fallen rather than risen, Bob would have lost $200 even though the company itself is only worth $1000. This is because he bet on its value decreasing, and it did (contrary to his expectations). This principle is the same when trading forex.
With a CFD, you do not have to deal with the costs of actually owning the physical stock (storage and transfer fees, for example). You only need to worry about whether its value will fall or rise. Now that you have clearer picture of what a CFD is, head to markets.com and start investing!