An Introduction to Contract for Difference (CFD) Trading

Contract for Difference, or CFD is an agreement made between two parties, the buyer and the seller (CFDs broker and client), stating that the buyer should pay the seller the difference between the initial value of an asset and its value when the contract is made. CFD trading enables traders to speculate on an asset’s price including currencies, shares, commodities etc and benefit from price movements (up or down) without owning the actual asset.

How forex works: Currency trading

To get into online forex trading, understanding the underlying foreign exchange market is vital. To start with, forex is the biggest and most liquid market worldwide with a $6.6 trillion daily trading volume. Forex involves trading currency pairs. In other words, it is the exchange of one currency for the other. The market is an OTC market meaning that there is no central location. Instead, the market consists of an electronic network of participants like a forex broker, an institution or an individual trader. 

There are generally 4 main currency categories: Exotics, minors, majors, and crosses. A forex currency quote consists of two currencies. The first is called base currency and the second one quote currency. Taking the EUR/USD currency pair as an example, if you were to buy it, that would mean that you would be buying euros while selling dollars. If the EUR strengthens against the dollar, then you would generate profit. On the contrary, if the EUR weakens against the dollar, then you would take a loss. The price difference depends on the exchange rate which is reflected in the currency quote. Therefore, if the exchange rate for EUR/USD is 1.1322, this means that you can exchange 1,000 euros for 1,132.20 dollars.

Symbolically, a currency pair reflects how powerful an economy is compared to another. There are also other various political, technical and economic events that have a great impact on a country’s currency. Read on to get a deeper understanding of the fundamentals driving a specific currency pair and then you can move on to understanding how CFDs work.

What are the determinants of the exchange rate?

There are many determinants of the exchange rate (such as supply and demand of individual currencies). There are a few governments that follow a fixed exchange rate wherein such rates are decided by the government or respective central bank of a nation. On the other hand, floating exchange rate regime is also followed (generally) wherein the following could be deemed as most important determinants of the exchange rate:

• Prevailing economic conditions: Economic conditions such as fiscal policy, monetary policy, government budgets, the balance of trade, inflation levels, economic growth, and productivity levels of a nation are all crucial determinants of the exchange rate of a currency.
• Prevailing political conditions: Various aspects such as political stability and the strength of a ruling government could be deemed as having a positive impact on the exchange rates.
• Prevailing market psychology: The existing market psychology including economic numbers announcements, long-term trends, technical trading considerations, and cognitive bias in a region also have a direct implication on the determination of exchange rates.

Forex and Forex CFDs

As already discussed, trading forex refers to exchanging one currency for another. Traders can do that on the MT4, which is the best online trading platform for beginners. CFDs are a different way to trade forex currency pairs. Trading CFDs allows traders to place trades on currency pairs by speculating on the price movement of the specific asset. Instead of specifying a set amount of base currency, CFDs are cash-settled meaning that there is no delivery of physical goods or securities.

A key characteristic of CFD trading is that traders can use leverage which helps in increasing one’s size of trade which is bigger than the initial capital of the trade. However, keep in mind that although your exposure is increasing, potential losses are too.  

CFD Trading in Gold

• Gold is a haven for forex trading and so there is high liquidity in commodity markets for gold CFDs.
• There is no fixed expiration date, so the investor’s money does not get blocked, and the flexibility for exit makes it lucrative.
• It is also a high leverage market, so the investor can deposit a marginal amount for trading high volumes of this precious metal.
• While it is highly profitable for a good trade, when the market goes against the intended trade, there could be high charges for overnight funding.
• The brokers also require upfront margins in case of shortfall, which may lead to liquidation of trade.
• There is also no bar as to spot or futures market for entering into CFDs. Whichever market is taken as reference, both the price quotations will follow from the same.
• CFDs in gold can also be entered by trading in precious metal index, 70% of which comprises of weighted gold and silver.
• Gold is paired with a country’s legal tender for trading through CFDs, and is denoted as XAUGBP for UK.
• The movement in price is denoted in pip which is 0.01 for gold contracts.
• CFD lot sizes are identical to units of underlying commodity, and the same rules for lot thresholds shall apply to CFDs when entering the contracts.

For example, if the minimum contract threshold for trading in gold is 0.1 lot (where 1 lot=100ounces for standard gold contract), then the minimum order quantity will be 10ounces. Since unit of CFD is troy ounces (1 troy ounce=1.1 ounce approx.). Hence lot size will be the same in CFD as in a standard gold contract.