CFDs are an accessible and popular tool for forex and financial traders. But if you’re still getting to grips with the details, you’ll be wondering what is the definition of a CFD? A ‘contract for difference’ (CFD) is an agreement, where the investor buys a contract anticipating a change in value on a particular financial product. By purchasing a CFD you’re not buying the underlying asset. This means you can use leverage to increase the size of the contract using a smaller deposit (margin).
CFD trading is an accessible way for forex traders to speculate on the most popular financial trading markets such as forex or equities. If you want to invest on the movement of the US Dollar against the Euro, or you have a feeling that Facebook stock is going to rise rapidly soon, rather than spending thousands on stock you would take out a CFD. A contract for difference (CFD) allows you to use a fraction of the total value of a lot to invest. A standard lot size in forex trading is 100,000 currency units (Dollars, Euros etc), although you can also trade mini lots (10,000) and micro lots (1,000). When you open your trading account you deposit money into your account, which is your balance or your equity. If you then want to open a CFD you would use the leverage available to create your margin for your trade.
For example, if the leverage available is 10:1 you could put in $1,000 to access an investment of $10,000. The $1,000 is your margin (deposit) and the available leverage of 10:1 means you stand to make profits or losses based on the full value of the $10,000. So if your trade goes up 2% to $10,200 and you close your position, you would make a profit of $200. Your initial margin was $1,000, so you have made a profit of $200 on your $1,000 margin, which is the equivalent of a 20% return. However if the trade went down 2%, your loss of $200 means you would have made a 20% loss.
This extremely simplified example also doesn’t take into account any fees associated with the transaction. Some brokers might charge a commission or a flat fee on any trades as well as the spread.
Take a look at our Spreads and Margins explanation to find out more.