Trading Indices with CFDs

The idea behind trading indices with CFDs

Index CFD trading allows you to speculate on stock market performance without becoming embroiled in the ups and downs of trading individual shares. They arguably carry less risk too, at least compared to gambling on the fortunes of just one company, because all of the different things that can affect a firm’s fortunes are stripped from the equation with CFDs.

If you believe the NASDAQ is going to rise, you can open a CFD that lets you capitalise on this prediction. Or if it seems likely to fall, you can make money from that as well. A CFD position lets a trader speculate on the price moves of an index between two dates. Index CFDs let you cover all the major indexes in the world, so it essentially removes all borders. If there is an index in a particular country, then chances are that someone will let you open a CFD position on it.

So, why would you want to focus on share indexes? Well, since each one benchmarks the market performance of the economy that it belongs to, you’ll find it easier to get a sense of which direction the market might go. It doesn’t require the same level of research to understand an entire market as it does to understand an individual company, and you don’t have to worry about clearing fees either. Also, the majority of the main indices reflect the performance of blue-chip companies so they also offer a great measure of market sentiment. Your Index CFD gives you a position on blue-chip index shares, which you would expect to not be too volatile.

Short-term traders prefer a popular stock market index like the NIKKEI or the Dow Jones because they’re easier to analyse than less popular ones. Usually, the indices will move predictably within well-established levels of support and resistance. More popular markets tend to be the FTSE 100, Dow Jones, S&P and Germany’s DAX index, the CAC-40 in France and the Nikkei 225 in Japan.

An Index CFD is a type of Contract for Difference that lets investors predict the movements of an index for profit (although prices may differ from the actual index levels). Index CFDs rely on the current best estimate of the cash price of the market, which means the quotes are taken from the corresponding futures contract and a fair value adjustment. The adjustment is there because the financing fee for the open-ended CFD is charged for each night, but the futures price reflects the remaining cost of funding up to the contract expiry date.

Index CFDs take a broad view of markets by their nature, so it’s easier to capitalise on what you see as broad market trends. There’s no need to get into the nitty-gritty details of a particular company’s fortunes, and unlike a share CFD, an index CFD has the added attraction of not being able to hit zero because the chances of all those blue-chip companies doing that at once are practically zero unless the world ends.

Although news events can cause fluctuations in an index they are not likely to be as wild as they are with single shares or even single sectors. If you take an index like the Russell 2000, it has masses of diversification built-in, even compared to the Dow, because it’s made up of 2000 American companies. Some will be rising some will be falling, but again, a mass movement is relatively unlikely. You can long and short an index with a CFD, which gives speculators the chance to profit from downtrends as well as uptrends. This approach is a lot cheaper and easier than investing in a lot of stocks too. It’s probably the cheapest way to diversify your portfolio, and you don’t even need to stick to the same country, because you’re not actually investing in anyone else’s territory. You’re always within your own jurisdiction, speculating on something that happens to be occurring elsewhere, 24 hours a day. And that 24-hour trading means that there is a lot less likelihood of gaps appearing, as you find happens with single stocks, and there’s less need to use guaranteed stops with these markets too.

CFDs also bring the benefits of trading on margin. With a big index, this would usually be pegged at somewhere between 1 and 3% of its value, although you also might need additional funds to plug running losses. A 1% margin would give your $2000 cash investment the leverage to trade $200,000 on an index CFD. The value per point for the CFD is measured in the local currency, such as the yen for Japan’s NIKKEI. This makes it the most cost-effective way of betting on foreign assets.

Providers make their commission by adding a margin to the bid-offer spread. Each contract equates one unit of the base currency to one index point. The minimum trade size is one CFD, which for the Dow Jones means exposure of $1 for each index point (so if you bought a Dow Jones CFD it would be the same as putting in $28,000; assuming that it’s at the 28,000 level). You won’t normally pay commission on trading index CFDs, but a couple of points will be added to the spread.

The CFD dealer or broker will quote you a bid and an ask prices and just like a forex trader, it’s the difference (or spread) between these two where he generates his profits. And he doesn’t need to underwrite the contract or put any of his own money at risk either. All he needs to do is match buyers with sellers, those who want to take a long position with those who want to take a short one.

It’s as easy to go short on an index as it is to go long, and your only additional cost is the finance charge that comes with keeping an overnight position open. The charge is linked to LIBOR (if you’re in the UK) but since interest rates are low this will only set you back about 1 FTSE index point at most.

As this is a margin trade, every day you hold a position open, you’ll be charged the interest on the amount borrowed. In essence, you are gambling on the value of the index and whether it will gain or lose, but there is no stamp duty or capital gains tax to pay because you never actually own any shares.

To give you an example of how this would work, let’s say that you think the NIKKEI is about to rise. The price at present is 20000, and you receive a CFD quote for between 19980 and 20010. So, a CFD on the NIKKEI would expose you to the tune of $20,000. So, you might invest in a long position at 20000, and profit from any movement above that figure. This position would cost you just over $600 at 3%. If the index rises to 20300 you will profit by $156 netting you a healthy 25% profit on your initial outlay.

Another aspect of Index CFDs is that you can sometimes trade when markets are closed. This can give you some insight into how the index will perform the next time it’s open and in such cases, the prices will be influenced by both the provider’s ‘book’ and also on movements in whichever exchanges are still open.

The last advantage of Index CFDs we should mention is for hedging. So, if you’ve bought some NIKKEI stocks and you’re worried that it’s about to drop, rather than getting rid of them, you just open a short position on the NIKKEI to offset your losses without having to sell your stock.

CFD vs Binary Options CFD vs Forex What is Forex? What are the Best Currency Pairs to Trade? Stocks and Stock CFDs: Key Differences and Why They Matter