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What are forex CFDs?
Making profit on the price movement without owning the asset itself. CFD stands for 'Contract For Difference', a tradable contract between a client and a broker, who are exchanging the difference in the current value of a share, currency, commodity or index, bond, and its value at the contract's end.
Unlike Forex, where a profit is made on purchasing and selling large amounts of currency, CFDs allow making a profit on price movements without owning the asset itself.
CFD trading offers several advantages to a trader in comparison to trading physical shares. Among them there are:
- No shorting rules or borrowing stock - CFD instruments can be shorted at any time without borrowing costs because the trader doesn't own the underlying asset.
- No day trading requirements - The CFD market is not bound by minimum amounts of capital. It has no restrictions on the number of day trades and all account holders can day trade if they wish.
- Higher leverage - The higher the leverage, the bigger the possible profit is.
How does leverage work in forex trading?
As was mentioned above, CFD contracts provide leveraged access to the market, so the trader can access a much larger portion of the market than what they would be able to purchase outright.
Trading gold CFDs with leverage
For example, you will have to spend 1,200 USD for purchasing an ounce of gold. Yet with a leverage rate of up to 1:20 (meaning a trader could trade up to 20 times the value of the deposit), a trader could trade on the full value of an ounce of gold (1,200 USD) using a $60 deposit.
Quite the same, to purchase 3,000 US dollars with Euro, you will have to spend 2,700 EUR. But with the help of the leverage rate of 1:30, you can access 3,000USD worth of the EUR/USD currency pair as a CFD having just 100 EUR. The size of the potential profit a trader could make is the same as if they had invested in the asset outright. The risk here is that potential losses are magnified to the same extent as potential profits. Fortunately, traders can use trusted broker's insurance to avoid the impacts of leveraged losses.
Different levels of leverage can affect your trading, take a look at the Forex leverage infographic below:
Forex glossary appendix
For afters hold on some key Forex terms that were mentioned in this part.
Leverage is a capital provided by a Forex broker to buffer the client's trading volume. A 1:10 rate of leverage for $1,000 deposit on account, will allow trading $10,000 worth of a currency pair. If succeeded, the leverage may maximize the profit up to 10 times. Be cautious: in case of failure, the leverage also multiplies the losses to the same degree. If you go overdrawn and have less than $0 on your account, you may trigger a broker's negative balance protection settings (if trading with an ESMA regulated broker), which will result in the trade being closed. Good for you: it means that your balance cannot move below $0, so you will not be in debt to the broker.
Margin is the money borrowed from a brokerage firm to purchase an investment. It is the difference between the total value of securities held in the trader's account and the loan amount from the broker. Buying on margin is the act of borrowing money to buy securities.
Pip is the base unit in the price of currency pairs or 0.0001 of the quoted price. For instance, when the bid price for the EUR/USD pair goes from 1.1334 to 1.1335, that represents a pip change of one.
Spread is the difference between a currency pair's bid and ask price. Popular currencies' spread is often low - sometimes even less than a pip. For pairs that aren't traded as frequently, the spread tends to be much higher. Before a Forex trade becomes profitable, the value of the currency pair must cross the spread.