How do index CFDs work? | Indices 101

Index CFDs provide a quick and convenient way to trade the overall stock market. They are a popular alternative to buying individual shares. How does indices trading work and is it right for you?

By using a CFD, a trader can trade stock indices without owning the stocks in the index. For example, instead of buying all 30 stocks in the Dow Jones Industrial Average, a trader could buy the Wall Street 30 CFD.

Reminder: What is a stock index?

A stock index is a collection of different stocks that are grouped together and an average price is taken for all the stocks in the index, which creates the price of the index. The best-known stock indices like the Dow Jones and S&P 500 are also known as stock averages because of the way they are calculated.

The original index was the Dow Jones which simply consisted of the shares of the 30 biggest industrial companies in America. Now every country has a benchmark stock index, considered the ‘go-to’ price to judge that country’s market performance.

2nd Reminder: What is a CFD?

CFDs (which stand for Contracts for Difference) reflect the price movement of an underlying asset. When trading a CFD, you don’t own the underlying asset. The purpose is simply to speculate on the price movement of a financial instrument. In this case, we are discussing index CFDs but a CFD can also be based on other asset classes like forex markets, commodities or cryptocurrencies.

Most popular index CFDs

Here are the most widely-watched global indices and their CFD equivalents.

Stock Index Index CFD
S&P 500 US 500
DJIA Wall Street
Nasdaq 100 US Tech 100
Xetra DAX Germany 30
S&P/ASX 200 Australia 200
FTSE 100 UK 100
SMI Switzerland 20
Euro Stoxx 50 Euro Stocks 50
Nikkei 225 Japan 225

 

How are indices calculated?

Fortunately, individual traders needn’t calculate the value of the index because they are widely published on the internet and are live prices for the indices are streamed into the online trading platform.

Still, it’s useful to understand what it is you are actually trading because the way an index is made will affect its performance.

Usually, every index starts with a value of 100 when it is created. The return on each stock is calculated on a daily (and even intraday) basis and then averaged to give a return for the index. The next day the returns are added to the new index value after the first day. Historically stock markets rise in value over time so end up with values that are many multiples of 100.

There are three main ways a stock index is calculated, and they vary based on which shares within the index are given more or less weighting. A stock with a larger weighting in the index will affect the value of the index

Equal Weighted Method

This is probably least common but it is the simplest. Each stock in the index is given an equal weight, no matter how big the company is or how famous the founder is. The return of each stock is added up and divided by the total, and that gives you the return of the index.

Market Capitalisation Method

The idea here is to create a situation where bigger companies have a bigger impact on the index than smaller ones. This does make intuitive sense because the larger companies tend to earn more profit, hire more employees etc, making them more important to the market. Each stock in the index is given a value out of 100 and weighted based on the market capitalisation of the company (market cap = share price x no. shares). Most global indices, including the S&P 500 and SMI are market-cap weighted.

Price Weighted Method

In this method, more importance is attached to the share price than to the market cap of the companies in the index. As such, stocks with the higher share price have a larger weighting than those with a smaller price. The Dow Jones Industrial Average is price-weighted.

Where does the index CFD price come from?

It’s important to understand that the index itself is purely a mathematical calculation and cannot be traded. The main alternatives to using an index CFD are buying all the individual shares in the index, trading index futures or investing in an index ETF.

Index futures

Index CFDs typically use the index futures contract as the underlying asset. CFD brokers will typically offer the front-month and future month contracts where prices closely resemble the underlying market. In these instances, the index CFD will expire just before the underlying futures market expires.

Cash Indices

The second, and typically more popular option is to trade a rolling ‘cash contract’ where the aim is to use the futures contract to construct what the real cash value of the index is, adjusting for things like interest rates and fair value. The advantage here is that the CFD will automatically rollover from one month to the next and never expire.

Benefits of index CFDs

  • Diversification
  • Convenience
  • Low cost
  • Can short the index
  • Trade with leverage
  • Hedge existing portfolio

 

Buying or selling an index gives you exposure to an entire stock market or economy with just one trading position. This kind of diversification would be costly and hard to implement in a portfolio with purely individual stocks. Each stock would need to be purchased with a corresponding commission and if you were being true to the index, the weightings would need to be calculated too.

If you feel confident that the Swiss economy will do well and so overall Swiss companies will improve their profits, an appropriate trade would be to buy the SMI index. However, if you had done some research and believed a new drug produce by Swiss pharmaceutical company Roche would improve Roche earnings, it would be more appropriate to buy Roche shares than the SMI index.

Index CFDs are typically traded commission-free with all fees incorporated into the bid-ask spread.

Another popular use of CFDs is to go short the market. Borrowing the real stock and going short the individual shares can be cumbersome, while the process and cost for going short an index CFD is just the same as process for taking a long position.

Index CFDs are typically traded using leverage, meaning the CFD only needs to commit a smaller initial deposit to initiate the trade, known as margin. Using margin gives you greater exposure to the market because profits and losses will be calculated based on the full position size, not just the funds used as margin.

The ability to go short is especially useful if you want to hedge an existing portfolio using the index. For example, a Swiss investor has a portfolio of 10 Swiss stocks but feels the overall Swiss stock market has gotten a bit over-extended and may be due a correction. They can sell the SMI index CFD short, which will offset the long positions in their portfolio.

Getting Started Trading Index CFDs

 

Step 1: Decide to use CFDs for your index trading

Step 2: Opt for either cash indices or index futures

Step 3: Register for a FlowBank trading account

Step 4: Select the index you wish to trade

Step 5: Go long or short the index

Step 6: Monitor your position on the FlowBank app

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