Forex and CFD are two appealing markets for investors. This article aims to look at both markets and provide a general picture of their functionalities and characteristics, so that you have a basic understanding of how they operate. In the following paragraphs, we will explain each one separately and then elaborate on the similarities and the differences between the two.
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What is FOREX?
Currencies are the pillars of any economy that connect suppliers with consumers. Foreign Exchange or Forex (FX) is the largest market by volume and liquidity, and provides the means to exchange fiat currencies for cross-border purchases, travelling or trading per se. The trading is done in over-the-counter (OTC) markets on weekdays (24/5). Also, the market is available worldwide, and anyone can participate in it.
How Does FOREX Work?
Traders can exchange currencies against each other in pairs. For example, if you are running a business in Berlin and you need a service from a company located in New York, you can convert your Euro to US dollar using a EUR/USD exchange rate to pay them. Or you can take profit from the difference in interest rates by buying currencies with higher interest and shorting currencies with low interest rates, meaning the market works both ways. The subtraction of ask and bid determines your gain or profit.
The Forex market formerly did not aim for the retail market, and the trading was done mainly by commercial and investment banks because trading in the Forex market required large amounts of money. But with the advent of the Internet, retail clients could join the market through a virtual online network of banks and brokers. Most brokers provide considerable leverage for clients who have small accounts, facilitating their activity in the market.
What is CFD?
Contract for difference (CFD) is an agreement between a buyer and a CFD broker that obliges the latter to pay the difference between the current market price of an asset and its price at the time the contract was made. It should be noted that the underlying value of an asset does not matter for the trader because they do not possess the asset; what matters is the price change. Moreover, there is no building out there as a center of CFDs; instead, the contracts are made through a network of institutions in a decentralized manner. In a CFD market, traders can make various investments such as treasury, stock, index, sector, and commodity, and thus, this allows them to have a diverse portfolio.
How Does CFD Work?
CFDs take place in listed OTC markets, and they are legal in most major trading countries, including the UK, Germany, Switzerland, Singapore, Spain, etc. but illegal in the US. In this market, the trader does not have to pay the full price of an asset. Instead, they can pay a fraction of the money for the margin, and the amount of this fraction is decided by the broker. By paying for the margin, the broker allows the trader to buy more of an asset than they can, and in a way, lends money to the trader. This is referred to as the leverage effect.
The CFD market works both ways, and the trader can take advantage of rising or falling price movements. For example, suppose the value of an asset you own increases. In that case, you offer your holding for sale, and the subtraction of the opening (purchase) price from the closing (sales) price determines your profit, which will be added to your brokerage account. Otherwise, if you predict a falling movement for the price of a particular asset, you open a sell position and close the position by placing a buy order on your predicted pip.
Similarities Between CFD and FOREX
CFD and Forex have several similar characteristics. The first similarity is that the trader can place long and short orders, and the cost of the order in both markets is calculated based on the spread. Second, in both markets, the buyer does not physically hold the possession of an asset but instead benefits from the markets’ fluctuations between opening and closing a position. For example, when you trade EUR for USD in Forex, you do not possess any EUR. The next common ground between Forex and CFD is the market they use; they both operate OTC market. In an OTC deal, the transactions take place in a decentralized network of different financial institutions. Also, CFD and Forex share the same platforms with similar features and pricing methods, so the traders will not need to shift between platforms to make their transactions.
Differences Between CFD and FOREX
The primary difference between Forex and CFD is that Forex is limited to currencies while CFD covers a wide range of assets. As a result, trading in Forex is less demanding compared to CFD, which is somewhat complex and more suitable for expert traders. The second difference concerns the contract size, while in Forex, there is a fixed set of lot sizes for every transaction. In CFD, the contract size is more flexible and varies across different instruments. The third differing characteristic is that of market influence; price movements in Forex are affected mainly by macroeconomic and significant political events, but in CFD, other relatively minor elements such as supply and demand, seasonality, intra-company changes etc. also affect the price movements. The last point here refers to the cost of trading, which in both markets is measured according to the spread, but in CFD, other charges such as commission and financing costs might be added.
Forex and CFD have specific characteristics which make them suitable for certain traders. For example, Forex is more suitable for traders who do not want to dedicate a lot of their time to trading or are not experts in financial concepts. On the other hand, CFD opens a broader horizon for traders and allows them to have a more extensive and more diverse portfolio than Forex. But it also requires the traders to constantly follow the market and be aware of the multiple factors that may influence their capital.