1.3 What is CFD (Contract for Difference)
In the context of financial markets, a Contract for Difference (CFD) is a contract between a buyer and a seller, where the seller pays the buyer the difference between the current value of an underlying asset and its closing value as specified in the contract (conversely, if the difference is negative, the buyer pays the seller).
CFDs are financial derivatives that allow traders to profit from the price movements of the underlying asset, whether it rises or falls. They are typically used for speculative purposes. CFDs are a leveraged instrument, which means they enable traders to potentially amplify both their profits and losses.
How can this be understood? Let’s illustrate with an example:
In City A, there is a house priced at 1 million USD. Peter tells Jessica that for every 1 USD the house price increases, he will pay her 1 USD, and for every 10,000 USD the house price increases, he will pay her 10,000 USD. Conversely, if the house price decreases by 1 USD, Jessica must pay Peter 1 USD, and if it decreases by 10,000 USD, she must pay him 10,000 USD. Jessica believes that the house will always increase in value and agrees to this bet.
Ultimately, due to an economic downturn, the house price decreases by 50,000 USD. Both parties settle the bet, and Peter profits by 50,000 USD.
In this process, neither Peter nor Jessica actually bought or sold the house itself; they did not own it. They were only speculating on whether the house price would go up or down. In this scenario, the house represents the underlying asset in a Contract for Difference, also known as the contract type.
Forex trading operates on a similar principle, but instead of houses, the underlying assets are currency pairs. Therefore, when we talk about forex trading, we are essentially referring to Forex Contract for Difference (CFD) trading.
For example, when the exchange rate of EUR/USD is 1.08000, and you enter into a contract to buy 100,000 euros (referred to as 1 lot), the contract’s current value is 108,000 US dollars. If the market price then moves to 1.09000, the contract’s value becomes 109,000 US dollars, resulting in a profit of 1,000 US dollars.
In the example above:
The fluctuation from 1.08000 to 1.09000 is typically referred to as a 100-pip movement in the forex market. The contract involves buying 100,000 EUR, which is often referred to as trading 1 lot. 0.1 lot would be equivalent to trading 10,000 EUR.