What is a CFD?
CFD stands for “Contract For Difference”.👍
A CFD is a tradable financial instrument that mirrors the movements of the asset underlying it.
A contract for difference (CFD) is an agreement between a “buyer” and a “seller” to exchange the difference between the current price of an underlying asset and its price when the contract is closed.
What a CFD allows you to do is speculate on the possibility of the PRICE of an asset moving up or down, without having to own the actual asset.
The logic behind trading CFDs is simple.
If the price of an asset goes up by 5%, your CFD does the same. If, on the other hand, the price goes down by 5%, your CFD also loses 5% in value.
CFDs enable you to bet on rising or falling prices without taking ownership of the underlying asset and can be used to trade a range of markets such as forex, shares, indices, commodities, and crypto.
For this lesson, we’ll be focusing on forex CFDs.
What is a forex CFD?
Forex CFDs allow you to trade on the strength (or weakness) of one currency versus another.
CFD trading is the buying and selling of contracts for difference (“CFDs”) via an online provider, who market themselves as “CFD providers“.
When you open a CFD position with a “CFD provider”, it creates, or issues, a CFD between itself and you. So a more accurate name for a “CFD provider” would be a “CFD creator” or “CFD issuer“. Regulatory agencies actually use the term, “CFD issuer”.
When trading forex, a CFD consists of an agreement (a “contract”) to exchange the difference in the price of a particular currency pair, between the time at which a contract is opened and the time at which it is closed
When the contract is closed you will receive or pay the difference between the closing price and the opening price of the CFD
- If the difference is positive, the CFD issuer pays you.
- If the difference is negative, you pay the CFD issuer.
With CFDs, you can speculate on price movements in either direction.
“Long” and “short” in CFD trading are terms that refer to the position you take on a trade.
You can open a “long” or “short” CFD position.
So when opening a CFD, you will have the choice to either:
- Buy the CFD at the indicated ask price (“go long”).
- Sell the CFD at the indicated bid price (“go short”).
The choice you make here will reflect your view of the direction in which you anticipate the price of the underlying asset will move.
This means that:
- A long position means entering into a CFD contract with the expectation that the price of the underlying asset will INCREASE in value. (“I bet the price will go up from here.”)
- A short position means entering into a CFD contract with the expectation that the price of the underlying asset will DECREASE in value. (“I bet the price will go down from here.”)
In order to close the trade, you will do the opposite of the opening trade.
In both cases, when you close your CFD position, your profit or loss is the difference between the closing price and the opening price of their CFD position.
The extent of the profit or loss will represent this difference multiplied by the size (number of units) of the position you traded.
(Plus any fees and other costs such as interest charges on positions held overnight).
As its name suggests, a CFD is a contract between two parties to exchange the difference in the price of an underlying asset, between the time at which a contract is opened and the time at which it is closed.
- If the asset rises in price, the buyer receives cash from the seller.
- If the asset falls in price, the seller receives cash from the buyer.
For example, if you think GBP/JPY is going to fall in price, you would sell a CFD on GBP/JPY. You’ll still exchange the difference in price between when your position is opened and when it is closed but will earn a profit if GBP/JPY drops in price and a loss if GBP/JPY increases in price.
CFDs are settled with cash, but the notional amount is never physically exchanged. The only cash that actually switches hands is the difference between the price of the underlying asset when the CFD is opened and when the CFD is closed.
The difference between the open and closing trade prices is cash-settled in the denomination that your account is in. There is no delivery of physical assets.
For example, when you close a CFD position involving EUR/USD, there are no actual euros or dollars physically exchanged.
With CFDs, you are basically betting on whether the price of the underlying asset is going to rise or fall in the future, compared to the price when the CFD contract is opened.
In the U.S., CFDs are banned so U.S. retail forex traders trade a product known as “rolling spot FX contracts“. From a technical standpoint, they’re considered different from CFDs, but from a functional standpoint, they are the same. Both are cash-settled contracts in a particular currency pair that gives you exposure to changes in the price for that currency pair.
When the contract is closed you will receive or pay the difference between the closing price and the opening price of the contract. Both allow you to obtain an indirect exposure to the underlying asset (currency pairs), which means that you will never actually own the underlying currencies, but you may gain profit or suffer loss as a result of price movements in the underlying asset as if you had actually owned it.
CFDs are referred to as “over-the-counter” (OTC) derivatives because they are traded directly between two parties rather than on a central exchange.
The two parties involved are YOU and your BROKER.
Instead of buying or selling physical currencies, you are trading CFDs, which is a contract that enables you to speculate on whether the price of a currency pair will rise or fall.
CFDs = Leveraged Derivatives
We’ve already discussed how CFDs are financial products in the form of derivatives that enable retail traders to speculate on the changes in an asset’s price, without owning the asset itself, but another prominent feature of CFDs is that they are traded on margin, which provides leverage.
CFDs are leveraged derivatives.
Trading with leverage means that you can open a large position size without having to put up the full amount.
Let’s say you wanted to open a GBP/USD position equivalent to a standard lot (100,000 units). Without leverage, you’d have to put the full cost upfront. But with a leveraged product like a CFD, you might only have to put up 3% of the cost (or less).
This means that you can open a CFD position, while only putting down a small percentage of the value of the total position size as a deposit (“margin”).
The amount of money required to open and maintain a leveraged position is called the “margin” and it represents a fraction of the position’s total value or size.
When trading CFDs, there are two types of margin.
- The initial margin is the initial deposit required to open a position.
- The maintenance margin is the additional margin that’s required if your position gets close to incurring losses that the initial margin (and any additional funds in your account) won’t be able to cover.
If you fail to maintain the margin requirement of your trade, you will receive a margin call from the CFD provider asking you to deposit more funds in your account. If you don’t, the position will be automatically closed out and any losses incurred will be realized.
This is known as “trading on margin“.
For example, for a CFD contract with a leverage ratio of 50:1, which is a margin requirement of 2%, you would only have to deposit an initial margin of $200 to gain exposure of $10,000 worth of EUR/USD.
A leverage ratio is the ratio between the total notional CFD position value (that to which the retail trader is exposed) and the amount deposited by the retail trader (the initial margin requirement).
You are effectively “borrowing” the other 98% of the value of the CFD.
Profits or losses are based on changes in the value of the total position size (or “notional value”).
This means that although you only pay a fraction of the total notional value of their CFD position, you are entitled to the same gains and losses as if you paid 100% of the total notional value.
For example, if the total value of your initial position in a CFD trade is £10,000 and the leverage ratio offered by a firm is 100:1, the initial margin requirement for you would be set at 1% of £10,000, so you would need to deposit £100.
A market movement of 0.5% against your position, originally valued at £10,000, would result in a 50% (£50) loss against your deposited margin.
The leveraged nature of the CFDs means that retail traders can be exposed to losses exceeding their deposited funds. Depending on the leverage used and the volatility of the underlying asset, the speed and volume of the losses can be significant.
We commonly see leverage ratios of up to 500:1 for forex CFDs. With a leverage ratio of 500:1, a retail trader may open a CFD position worth $1,000,000 with an initial deposit (“margin requirement”) of just $2,000!
Such high leverage ratios make CFDs particularly price-sensitive.
In fast-moving markets, prices can gap and losses can exceed the initial deposit.
Many retail traders can (and do) go into a negative account balance. This means you can lose all your money and owe more money to your CFD provider.
Leverage is what makes forex trading appealing because it enables traders to open larger positions than what they can afford with their own money which increases the potential for huge returns.
New to margin trading and unfamiliar with all this margin jargon? Check out our lessons on margin in our Margin 101 course that breaks it all done nice and gently for you.
Summary
New traders may wonder how it is possible for forex traders to buy or sell currencies they don’t own.
They’re also often confused by the concept of selling something before buying it.
The key to the answer lies in the fact that the trader is trading a derivative, not the actual currencies themselves.
Because you and your forex broker are exchanging agreements with each other, rather than the actual underlying assets, there is no need to “own” anything before selling.
These derivatives are called “contracts for differences” or “CFDs“.
A derivative is a financial instrument whose price is dependent upon or derived from the price fluctuations of an underlying asset.
A CFD is a contract under which two parties agree to exchange the difference in price between the opening price and closing price of the contract.
When trading CFDs, you are effectively betting on whether the price of the underlying asset is going to rise or fall in the future, compared to the price when the CFD contract is opened.
The more the asset’s price moves in the direction you’ve predicted, the more you’d profit. But the more it moves against you, the more you’d lose.
You can open a CFD while only putting down a small percentage of the value of the trade. This is known as “leveraged trading” or “trading on margin“.
In the U.S., since CFDs are prohibited, retail forex traders trade a slightly different product called “rolling FX contracts or “rolling spot FX contracts”.
But both products basically trade forex the same way. Tomato tomahtoe. 🍅
In industry lingo, together they’re known as “retail FX/CFD contracts“.
Forex brokers create these derivatives, “CFDs” or “rolling FX contracts” for retail traders.
Because retail traders can’t access nor trade the spot FX market, this is the only way that we’re able to speculate on just the prices of currency pairs (or “trade the forex market”).
But if you’re not trading IN the spot FX market, WHERE exactly are you trading then? 🤔