What is a CFD?

CFD is an acronym for Contract For Difference. CFDs are a type of derivative. This means that the price of a CFD is derived from the value of the underlying asset. There are many different types of underlying assets that CFDs derive their price from, such as currencies, commodities, indices and shares.

Rather than trading the underlying asset itself, many traders opt to trade with CFDs, which means that they never actually own the underlying asset, but instead speculate or invest in the movements in its price. A CFD is a deal where two parties agree to exchange money based on the change in value (the difference) of the underlying asset between the point at which the deal is opened and when the deal is closed.

If the value of the underlying asset increases, then the buyer makes money. If the value falls, the buyer loses money. Inversely, the seller makes money if the asset falls in value and loses money if it increases in value. CFDs can either be traded Over the Counter (OTC) or through an exchange (Exchange Traded CFDs).

ForexCT offers an OTC CFD service, whereby the contract is made between our clients and us as counterparty to those transactions.

What is Forex?

Forex is a type of CFD. Forex or FX — is an abbreviation for foreign exchange and is used to describe trading in the foreign exchange market by investors and speculators. The Forex market is the largest and most liquid market in the world with daily turnover of around $5 trillion. The power and size of this market is phenomenal and it dwarfs all of the major stock exchanges around the world. (See Chart 1)

In a Forex trade, you are simultaneously buying one currency and selling another. The buy/sell decision in forex is the same as the basic principle underpinning the share market. If a trader believes that a companys share price will rise (or the currency will strengthen), then he or she would buy. If a trader believes that the share price will fall (or the currency will weaken), then he or she would sell.

Lets take the Australian dollar and US dollar pair (AUD/USD) as an example. Imagine a situation where the AUD is expected to strengthen in value relative to the USD. In this case, a trader would buy AUD and sell USD. If the AUD actually does strengthen in value, the purchasing power to buy US dollars has increased. Therefore, the trader is now able to buy back more USD than they had to begin with, resulting in a profit.

What is an exchange rate?

The Forex market is quoted as one currency in relation to another. The first currency listed is the base currency. The second currency listed is the quote currency. For example, in the EUR/USD currency pair, the Euro is the base currency and the US dollar is the quote currency.

The price represents how much of the quote currency is needed for you to get one unit of the base currency. Lets assume the EUR/USD is trading at 1.3050. This means that for every 1 euro of the base currency (EUR), you would get $1.3050 of the quote currency (USD).

How do I read an exchange rate?

There are two types of quotes:

Direct quote: The price of the base currency in terms of the quote currency (e.g. in Japan, a direct quote for the USD would be 100.28 JPY = USD 1)

Indirect quote: The price of the quote currency in terms of the base currency (e.g. in the EU, an indirect quote for the USD would be USD 1.33 = 1 EU)

Regardless of whether the pair is a direct quote or indirect quote, the currency pair always has a bid price and ask price. The bid price is price at which the trader sells the currency and either initiates a short (sell) trade or closes a long (buy) trade. The ask price is price at which the trader buys the currency and either initiates a long (buy) trade or closes a short (sell) trade.

What is a pip?

Pip is an acronym for percentage in point and is the smallest price increment in Forex trading. Most currency pairs are quoted to four decimal places, except the Japanese Yen pairs. The fourth spot after the decimal place (100th of a cent) is generally what traders look at in order to count pips. One point movement in that fourth decimal place equals one pip. For example, if the AUD/USD was trading at 1.0500 and the price moved to 1.0501, then this represents a one pip movement.

What is the spread?

When you trade Forex CFDs, you do not pay commission; you pay a spread. The spread is measured in pips and is the difference between the bid price and ask price. The bid price is the price at which a party is willing to buy while the ask price is the price at which a party is willing to sell.

In this example, the spread is 3 pips.

Spreads will generally differ according to currency pairs, but as a client of ForexCT, you will always have fixed spreads. This means that even if the market is volatile because of a major news release or other indicators, we will not widen your spreads.

How do I use leverage?

When you trade Forex CFDs, you trade a leveraged derivative product. Leverage allows traders to increase their exposure to currencies and potentially magnify their profits with a relatively small initial deposit. ForexCT offers its clients up to 400:1 leverage. What does this mean? It means that you can increase your exposure to 400 times the margin required for the trade. Lets look at an example.

You decide to open an AUD/USD trade.

Since you believe the Aussie is going up, the direction of your trade is BUY AUD, SELL USD.

The price is 1.0500.

The contract value is AU$10,000.

Now that you have the trade specifications worked out, you want to know the margin amount you need to open the trade. Think of the margin as a form of collateral, where the amount of collateral needed is determined by your leverage. Lets assume that you have 400:1 (or 0.25%) leverage on your trading account.

The required margin for this trade would be calculated as follows: Contract value x (Leverage %/100)

10,000 x (0.25/100) = $25

In other words, a deposit of $25 in your account is required in order to open a $10,000 AUD/USD trade and have full exposure to that $10,000 position. The key point is that with leverage, you do not need $10,000 margin in your trading account to open this trade you only need $25.