If you want to trade forex, then CFD forex vs. spot trading is a decision you’ll need to make. Which one is best for you will be down to your own appetite for risk, as well as your trading goals.
CFD vs. forex spot trading: why do you need to choose?
Both CFDs and spot trades are a way of trading the foreign exchange (forex) market, where traders seek to profit from changes in exchange rates between currencies.
All forex trades are done as part of a ‘pair’, which means you are always trading one currency against another.
Common pairs include:
EUR/USD
GBP/USD
GBP/EUR
But there are a lot of different pairs available to trade.
The first currency in the pair is known as the base currency, with the second currency known as the quote currency.
In a forex trade, you’re always trading the price of the base against the quote.
So, in a GBP/USD pair, you’re trading the price of the US dollar against the UK pound sterling.
In GBP/EUR, you’re trading the price of UK sterling against the Euro, and so on.
What is a forex spot trade?
By placing a spot trade, you simply buy and sell your chosen currencies at their current price, in cash.
Then, if the price moves in your favour, you can profit from it.
Let’s take a look at a GBP/USD forex spot trade example:
Say the exchange rate is £0.8 sterling for each dollar.
You buy $5,000 for a price of £3989.40. (0.8 of $5,000.)
The exchange rate changes to £0.9 sterling per dollar.
So, you sell your dollars, and in return you get £4,500.
You started with £3989.4, and you’ve received $4,500 in return.
This means you’ve made £510.6 in profit on this trade.
Had the exchange rate fallen to £0.7 sterling per dollar, you would only have received £3,500 back, and lost £489.40 on the trade.
If you have enough capital to make this kind of trade, forex spot trades can be an effective way to trade the markets.
So, what is a CFD forex trade?
CFD stands for ‘Contract for Difference’. This means that you and a broker agree to exchange the difference (hence the name) between the price of a forex pair when the contract opens, and the price when it closes.
When you trade CFDs, you don’t actually buy the currencies. You simply speculate on the price movement, and don’t ever own either currency in the pair.
The price of the CFD pair should roughly correlate with the real price pair, though there may be a slight difference depending on market conditions at the time.
So, why would you choose forex CFDs over simply buying and selling the currency for real?
There are 2 main key benefits to using CFDs to trade forex
CFDs enable you to go long or short on a forex pair with relative ease. If you believe that one currency will go down in value against the other, you may want to go short on the trade. When spot trading, this can be quite complex. When you trade CFDs, you can execute long or short trades using the same process.
CFDs enable you to use leverage. You can use leverage to access bigger trades with less upfront capital. So, say you want to place a trade on $10,000 US dollars. If you used leverage 1:10 on this trade, you’d need a tenth of the capital - $1,000 – to place this trade. Your profits and losses are calculated on the size of the trade, not on upfront capital. This means that CFD leverage can allow you to get higher returns on your capital, but it also means you take on a lot more risk, and can lose more than the money you put in. As always, never trade with more money than you can afford to lose.
So, which will suit me better? Spot trading or CFDs?
There are a few things to consider here:
How much capital do you have? If you have sufficient capital to fund the entire trade upfront, then spot trading may be a better option for you, as you won’t need to use leverage. (Though, of course, you may still choose to.) Of course, if you’re using leverage, you should still never trade with money you cannot afford to lose.
How experienced are you as a trader? If you want to be able to go long and short with relative ease, using a single trading platform, then CFDs may be more suitable for you. Though, again, you still need to be sure you thoroughly understand how CFDs work before you use them.
What is your risk appetite? If you prefer to take less risk on your trades, then the chances are you won’t want to use leverage, as it increases your risk and opens up the possibility of you losing more money than you actually put into the trade. If this is the case, then it may be spot trading is the better option.
Summing up
Whatever option you choose to use, the two most important things you need to consider are:
Never trade with money you cannot afford to lose.
If you’re going to use high-risk tools like CFDs or leverage, be sure you take the time to thoroughly understand the inherent risks involved.
ZH
