CFD Indices: Overview, How It Works and How To Trade

CFD Indices (Contract for Difference) trading allows traders to speculate on the overall performance of industries or stock markets. An index can track a specific industry and area of economy, specific stock market, or even an entire market. Stock indices allow traders to gain exposure to the performance of groups of assets or entire markets. ^[1]

Indices have different methods for weighing their constituents (e.g. price-weighted and market-cap weighted indices) and calculating their value. A stock index usually has a base year and a base value which is calculated based on the value of underlying constituents.

The index’s value increases or decreases based on the performance of its constituents. A change in the index’s value is often of greater importance than the actual value, as it indicates the performance of the market. ^[2]

Commonly-traded Indices

CFD trading has gained immense popularity in major markets around the world. The most popular indices include among others:

1. FTSE 100

FTSE 100 is a UK index of the top 100 companies listed on the London Stock Exchange (LSE) . It is calculated by weighing stocks by market capitalisation. It mainly includes the top 100 stocks with the highest market caps.

2. NASDAQ 100

The NASDAQ 100 is a US index of the top 100 non-financial enterprises on the NASDAQ stock exchange. Weights of stocks in this index are based on their capitalisation, with various rules imposed to regulate the influence of larger securities.

3. Dow Jones Industrial Average (DJIA)

The Dow Jones Industrial Average, also known as the Dow 30, is a US index of the 30 best performing companies listed on the NYSE (New York Stock Exchange).

4. S&P 500

The S&P 500 is a market capitalisation-weighted index of 500 companies with the largest capitalisation. Unlike the tech-heavy Nasdaq, the breadth of the companies included in the index makes it one of the best indicators of overall US stock market performance. This index is hence favoured by traders as it tracks a huge part of the US economy.

Advantages of CFD Indices Trading

• Traders’ positions are spread across several companies and industries, diversifying their investments and reducing the risk of drastic instability.
• Returns are determined by the overall performance of a stock index rather than specific stocks. Therefore, traders can potentially take advantage of the favourable performance of any of the underlying stocks on the index.
• Traders can “short” indices CFD if their performance is declining, allowing them to still take advantage of a bearish market.
• Indices CFD trading could reduce the in-depth analysis required because it entails speculating upon various global market movements, rather than individual stocks.

Disadvantages of CFD Indices Trading

• Traders do not own the stocks listed within indices in which they open CFD positions.
• Although CFD indices trading is more diversified than trading stocks, the value of an index could still undergo highly volatile changes. Traders can still lose more than their capital especially when trading with leverage. Therefore, it is important to exercise great caution when trading CFDs.
• • Some countries such as the USA have banned trading CFDs.

CFD Indices Trading Strategies

1. Follow the Latest News

It is paramount for traders to keep up-to-date on financial news and risk events taking place before deciding what stock indices they want to trade on. Changes in financial news can have a huge impact on indices based in the region and being able to identify possible movements increases your chances to take advantage of market opportunities. Moreover, it reduces the risk of being caught off guard by the market.

2. Hedging

CFD trading is commonly used to hedge investments because it allows you to “short” (sell) the index. For example, if your investment portfolio contains various stocks and you’re expecting a sudden decline, you can use CFDs as a trading strategy to potentially reduce your downside exposure by offsetting losses.

How to Trade Indices CFDs

1. Choose a Broker

There are many different brokers that offer CFD indices trading on various proprietary or online CFD trading platforms. Find a broker that offers all the right instruments for CFD indices trading.

Important factors to consider while choosing a CFD broker include:

• Leverage rates – Check and compare various margin trading conditions. A lower margin typically means the index requires a lower initial investment to trade.
• Spreads – Brokers usually gain from the spreads they offer to traders. A lower spread means traders need to make potentially less profit to cover the overall trade cost.
• Reputation – When dealing with indices trading it is important to consider the reputation of your broker, given that CFD trading is not properly regulated in some countries. Check whether the broker and their platform are regulated.
• Customer support – The inability to access your funds or make decisions on your position due to errors with the trading platform can be very frustrating, and not to mention painful if you incur losses. Therefore, traders should not overlook customer support – some CFD brokers even offer round-the-clock (24/7) support.
• Fees –  CFD indices trading can have many associated fees, such as transaction fees and overnight holding charges. Be sure to compare all the costs of using different brokers and consider them against the trading strategy you want to use.
• Deposits – Consider how accounts are funded (currencies accepted) and how many days the deposit will take to appear in your account so you don’t miss a trade.  

2. Open Your Position

Never invest more than you can afford to lose. 

Most trading platforms are fairly user-friendly, and opening or closing your position is straightforward. CFD indices trading platforms typically present options to sell (short) or buy (long) your chosen CFD index.

Going short means that the trader will take advantage of market opportunities when the index’s value falls; while going long if it rises. Most platforms offer traders detailed information about various instruments to help inform their decisions.

3. Monitor Your Position

Keep a close eye on all your positions after opening them. You may consider putting in place an automated exit strategy if possible. You can consider exiting your position to avoid losses if you think it’s going to fall past a threshold you are comfortable with. You can also place stop orders (automated limits), which will automatically exit your position, once hit.

The Bottom-line

CFD indices trading mainly involves speculating on the performance of companies in global markets. This helps spread the risk by diversifying exposure to underlying markets without having to cherry-pick individual stocks to trade.

As a result, there’s a lower risk of being exposed to major market movements in response to company news.

In indices CFD trading, traders do not have to perform as much thorough technical analysis of the underlying assets or individual companies. Investments are usually spread over various industry segments, reducing the hassle of having to identify potential companies worth looking into.

Unlike trading stocks directly, CFD indices trading can be done throughout the day, regardless of the time.

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Reference

1. “How do index CFDs work? | Indices 101 – FlowBank.” . https://www.flowbank.com/en/research/how-do-index-cfds-work-indices-101 . Accessed 7 Apr. 2022
2. “How do index CFDs work? | Indices 101 – FlowBank.” . https://www.flowbank.com/en/research/how-do-index-cfds-work-indices-101 . Accessed 7 Apr 2022