What exactly is a CFD?
CFD is an abbreviation for “Contract For Difference.”
A contract for difference (CFD) is a tradable financial instrument that mimics the movements of the underlying asset. A contract for difference (CFD) is an agreement between a “buyer” and a “seller” to exchange the difference between the current and closing prices of an underlying asset.
A CFD allows you to bet on the likelihood of an asset’s PRICE increasing up or down without needing to possess the actual item. The logic behind trading CFDs is straightforward.
If the price of an asset rises by 5%, your CFD rises by the same amount. If, on the other side, the price falls by 5%, your CFD will likewise fall by 5%. CFDs allow you to gamble on growing or falling prices without owning the underlying asset and may be used to trade a variety of markets including FX, stocks, indices, commodities, and cryptocurrency.
In this article, we will concentrate on Forex CFDs.
Forex CFDs enable you to speculate on the strength (or weakness) of one currency in relation to another. CFD trading is the purchase and sale of contracts for difference (“CFDs”) through an internet source that advertises itself as “CFD providers.”
A CFD in forex trading is an agreement (a “contract”) to exchange the difference in the price of a specific currency pair between the time the contract is opened and the time it is closed.
When the contract is concluded, you will receive or pay the difference between the CFD’s closing and opening prices.
If the difference is positive, the CFD issuer will compensate you.
If the difference is negative, you must pay the CFD issuer.
CFDs allow you to speculate on price movements in either direction.
In CFD trading, the terms “long” and “short” relate to the position you take on a trade.
You can open a “long” or “short” CFD position.
When you start a CFD, you will have the option of:
Purchase the CFD at the given ask price (“go long”).
Sell the CFD at the given bid price (“go short”).
The decision you make here will reflect your expectations for the underlying asset’s price movement.
A long position entails engaging into a CFD contract with the assumption that the underlying asset’s price would INCREASE in value. (“I bet the price will rise from here.”)
A short position entails engaging into a CFD contract with the assumption that the underlying asset’s price would DECREASE in value. (“I bet the price will fall from here.”)
To close the transaction, you will execute the reverse of the opening trade.
When you close your CFD position, your profit or loss is the difference between the closing price and the opening price of your CFD position in both situations.
The amount of profit or loss will be calculated by multiplying the difference by the size (number of units) of the position you traded.
(Plus any fees and other expenditures, such as overnight interest rates on positions held).
A CFD, as the name implies, is a contract between two parties to exchange the difference in the price of an underlying asset between the time a contract is opened and the time it is closed.
If the value of the asset rises, the buyer receives cash from the seller.
If the asset’s value falls, the seller pays the buyer in cash.
For example, if you believe the price of GBP/JPY would fall, you would sell a CFD on GBP/JPY. You will still exchange the price difference between when your position is opened and when it is closed, but you will make a profit if the GBP/JPY falls in value and a loss if the GBP/JPY rises in value.
Cash is used to settle CFDs, although the notional amount is never physically exchanged. The only money that changes hands is the difference between the underlying asset’s price when the CFD is opened and when it is closed. The difference between the opening and closing trading prices is settled in cash in the denomination of your account. There is no physical asset delivery.
When you close a CFD position involving EUR/USD, for example, no actual euros or dollars are exchanged. With CFDs, you are essentially betting on whether the underlying asset’s price will rise or fall in the future compared to the price at the time the CFD contract is opened. Because CFDs are traded directly between two parties rather than on a central exchange, they are referred to as “over-the-counter” (OTC) derivatives.
YOU and your BROKER are the two persons involved.
Trading CFDs, rather than buying or selling physical currencies, allows you to wager on whether the price of a currency pair will rise or decline.
CFDs = Leveraged Derivatives
We’ve already explored how CFDs are financial products in the form of derivatives that allow ordinary traders to bet on changes in the price of an asset without owning the asset itself, but another distinguishing aspect of CFDs is that they are sold on margin, which offers leverage.
CFDs are leveraged derivatives.
Trading using leverage allows you to open a large position size without putting up the entire money.
Assume you wished to open a GBP/USD stake equal to one standard lot (100,000 units). Without leverage, you would have to pay the entire sum up front. However, with a leveraged product such as a CFD, you may just have to put up 3% of the cost (or less).
This means that you can start a CFD account while simply depositing a tiny percentage of the total position size (“margin”).
The amount of money necessary to start and maintain a leveraged position is known as the “margin,” and it indicates a percentage of the entire value or size of the position.
There are two sorts of margin when trading CFDs.
The initial margin is the deposit made to open a position.
The maintenance margin is the extra margin required if your position is on the verge of accumulating losses that the initial margin (and any additional funds in your account) cannot cover.
If you fail to meet the margin requirement for your trade, the CFD provider will contact you and ask you to deposit extra funds into your account. If you do not, the position will be closed immediately and all losses will be realized.
This is referred to as “trading on margin.”
For example, for a CFD contract with a leverage ratio of 50:1, or a margin requirement of 2%, you would only need to deposit $200 to obtain exposure to $10,000 in EUR/USD.
You are effectively “borrowing” the remaining 98% of the CFD’s value.
Profits and losses are calculated based on changes in the total position size (or “notional value”). This means that even if you just pay a percentage of the whole notional value of their CFD position, you are entitled to the same gains and losses as if you paid the full amount.
For example, if the total amount of your initial position in a CFD trade is £10,000 and a firm’s leverage ratio is 100:1, your initial margin requirement would be set at 1% of £10,000, requiring you to deposit £100.
A 0.5% market movement against your £10,000 position would result in a 50% (£50) loss against your deposited margin.
Because CFDs are leveraged, retail traders may incur losses in excess of their invested funds. The pace and volume of losses can be severe depending on the leverage utilized and the volatility of the underlying asset.
For forex CFDs, leverage rates of up to 500:1 are common. A retail trader with a leverage ratio of 500:1 can open a CFD position worth $1,000,000 with a $2,000 initial deposit (“margin requirement”).
CFDs are particularly price sensitive due to their high leverage levels.
Prices can gap in fast-moving markets, and losses can exceed the initial deposit. Many retail traders can (and do) lose money on their accounts. This means you could lose all of your money and end up owing more to your CFD provider.
Leverage is what attracts traders to forex trading since it allows them to create greater positions than they can afford with their own money, increasing the possibility for huge rewards.
Next Lesson: Where Are Retail Forex Traders Actually Trading?