All forex traders, including beginners, have heard of CFDs at least once, which are among the most widely used financial instruments in the foreign exchange market. A CFD, an acronym for Contract for Difference, belongs to the category of derivatives and it is a contract signed between two parties in which the buyer, upon payment of an interest, receives the yield of an underlying financial asset, while the seller, at against the collection of an interest, undertakes to pay the yield on the underlying asset. The parties adhere to the exchange of a financial flow deriving from the difference between the price of the underlying respectively at the time of opening of the contract and at the time of its closing. CFDs were introduced about 20 years ago, and are gaining interest among forex traders recently. Some data show, for instance, that in the United Kingdom CFD trading is equal to 20.0% of the London Stock Exchange’s daily turnover.
Thanks to CFDs, traders operate on the price differences of the contracts, gaining or losing according to the difference between the purchase and the sale price of the underlying, multiplied by the number of CFDs traded. CFDs can be bought when a trader goes ‘long’, or sold when he goes ‘short’.
Trading a CFD is very similar to trading other financial instruments. However, its price is almost similar to that of the underlying instruments. To operate with them, it is not necessary to pay the full value of the transaction but it is sufficient for the trader to deposit a margin, normally between 10% and 20% of the transaction value, depending on the type of the instrument traded and its volatility. By purchasing a CFD, the trader does not become the owner of the underlying asset (currencies in the case of the forex market), but obtains a position that replicates the performance of the underlying itself.
During the period in which the position (either long or short) remains open, a sum reflecting interest and dividend adjustments is charged or credited to the CFD holder. In the case of long positions, dividends and interest are paid. The latter are usually calculated by adding a fixed percentage (spread) to a base reference rate (for example Euribor + x%). The opposite occurs in the case of ‘short’ positions (interest is calculated by subtracting a fixed percentage from the reference rate).