Forex vs CFDs

Two of the most popular choices for new traders considering getting involved in the financial markets are now forex and contracts for difference trading, or CFDs for short. Both are potentially highly lucrative and carry significant risks, yet some traders favour one over the other for a multitude of reasons. For comparative purposes, it’s worthwhile looking at the characteristics of each of these trading styles, to see where one beats the other in terms of the advantages they provide.

Round 1: Leverage

When it comes to the heart of the issue, leverage is that it’s all about. We need leverage, both in forex and in CFDs to deliver the kind of returns we know are possible, and in many respects forex needs leverage to survive as the liquid, highly traded market we know today. But when it comes to the degrees of leverage being traded, forex is simply miles ahead. In CFDs, 20:1 would be considered highly leveraged – that’s £2000 possible transaction size for every £100 of capital you invest. In forex, it’s more like 500:1 – that’s £50,000 for every £100 of capital you invest. This means that in forex trading, much smaller movements will yield a more substantial profit, and as a result CFD positions have to work harder to deliver the same degree of benefits.

Round 2: Volatility

Currency markets are notoriously sleepy, in volatility terms. They don’t move with the same vigour as some of the markets traded through CFDs, and in many respects that’s why leverage is such an important part of the forex game. Without it, the movements in the forex markets alone would be insufficient to satisfy the needs of traders, who would subsequently take their money to an alternative market where they could achieve more worthwhile returns. CFDs tend to be traded in markets which have a much greater degree of volatility, including many share markets, and in any event tops up that volatility by deploying a leveraged portion to each contract transaction. Thus, on the natural volatility stakes, CFDs may perhaps have an edge.

Round 3: Risk

While some traders get caught up in thinking about profits, the sensible trader thinks about risk. What is the risk of damaging your capital? Both CFDs and forex pose high levels of risk by comparison to standard investment types, and the reasons for this unique to each trading style produce virtually the same result. When you’re trading forex, dealing in leverage to a ratio of 500:1 is always going to pose a substantial risk. If markets turn against you, that’s a position that’s quickly going to bite. In CFDs, the leverage ratio might only be 20:1, but the markets themselves have a much more credible chance of swinging more heavily in the opposite direction, thus the two combine to reflect substantial degrees of risk in both forex and CFD trading.

Verdict

While both trading styles have their similarities, they also have unique points of difference, and in truth are perhaps suited to different applications. With forex, the scope of research is so much narrower and the dependence on economic goings on and current affairs much more substantial. In CFD trading, while the effort burden is bigger, wilder swings in markets mean it is possible to see high returns without becoming too massively leveraged. Both have their strengths and weaknesses, and the shrewd trader will recognise that having the ability to trade both might work out to be valuable for portfolio diversity.