What is a CFD?
'CFD' stands for 'contract for difference' and consists of an agreement (contract) to exchange the difference in the value of an underlying (currency pair, commodity, share, index, crypto) between the time at which the contract is opened and the time at which it is closed. If the difference is negative then the buyer must pay the difference to the seller. If the difference is positive then the seller must pay the difference to the buyer. When trading CFDs traders buy (go long) when they are expecting a rise, and sell (go short) when expecting a drop in value.
The CFD derivatives market is not standardised and is made up of buyers and sellers who trade OTC ‘over-the-counter’ (not on any regulated exchange), meaning that the broker is the counterparty to every transaction and there is therefore counterparty risk.
International banks & large investment firms act as liquidity providers by providing their own quotes for pricing CFDs based on the underlying prices, e.g., CFDs on FX pairs are based on the FX spot market. The brokers pricing and liquidity is usually received and aggregated from several such sources and can be affected by the available liquidity and pricing received from the above.
As a very simple example: if you buy a ‘contract for difference’ at $14 and sell at $16 then you will receive the $2 difference. If you buy a CFD at $10 and sell at $8 then you pay the $2 difference.
Basically, a CFD contract means that you are not physically buying the underlying, but through the CFD, you have exposure to the price movement of the underlying instrument.