Index CFDs

Most people are aware of what an index is, at least in the financial world. In the United States the common ones are the NASDAQ 100, the S&P 500 and the Dow Jones industrial average, or DJIA. In London we have the FTSE 100 and 250, in Germany the DAX 30, and Australia has the Aussie 200.

These indexes have all been assembled to reflect the overall health of the particular financial market, and provide a quick reference to the state of the economy. They are calculated by taking the number of different shares named in their title, and applying appropriate weightings to their values. The Dow Jones is quite exceptional in that it only takes the top 30 shares into account in its calculation, whereas most of the other ones take significantly more. However it is one of a longstanding set of indices established at the end of the 19th century by Charles Dow, and as such has become revered in the USA.

Trading an index allows you to take a view of the overall financial climate of any particular market or country. For many years, you have been able to buy mutual funds or exchange traded funds which reflect the movements of an index. Where index CFDs score, and the way in which they are superior, is that they can be used to trade in many different markets no matter where your broker is based, and they are more easily traded in and out than mutual funds.

Index CFDs tend to enjoy even better leverage than the equity contracts for difference. You are usually required to put only 5% down to trade the CFD. This means that if, for example, the index rises by 5%, you will have doubled your money if you took a long position. Of course, in common with all CFD trading, you can choose whether to take a long position, where you profit when the index goes up, or take a short position which gives you gains when the index goes down.

Make sure that when you trade using this sort of leverage you do not put yourself in a position where you cannot afford to lose. Bear in mind that these contracts are marked to market each day, which means that your broker may need to ask you for more money if the CFD goes the wrong way initially, even if it ultimately goes in the direction that you hope.

The pricing of index CFDs is slightly different from share (equity) CFDs. It is not usual to be charged a commission when trading index CFDs. The broker makes his money from the spread between the buying and selling price, which may typically be two or three points. Although this seems quite a low amount, if you’re doing frequent trading these differences can add up in relation to your profit, eating away at your gains. Therefore it is important that you shop around to find the broker who will give you the lowest spread.

The other way in which the broker will make money from your trading is by charging the daily interest each night for the margin borrowing which you are committing to. This is why contracts for differences should be considered only for active traders, and are not suitable for buy and hold investors. The interest rate may be as much as 6% to 8% per annum, which again when you break it down into a daily amount does not seem expensive, but will add up if you hold on to the CFDs more than a few weeks. The interest rate is usually set in relation to a publicized bank rate, such as the LIBOR rate in the UK.

You may be thinking that trading index futures would be similar to trading index CFDs, and wonder you should choose to use contracts for difference. In both cases, you are committed to the difference in value which the index experiences, whether for your profits or loss. However, the futures are only sold in larger size lots, so you have significantly greater flexibility by trading with CFDs.

The index CFD is useful if you are bullish on a particular market. The index CFD allows you to participate in the market gains without the hassle of having to buy individual shares. It is a very convenient tool to taking advantage of a market move. However, there are other ways in which you can profit by trading index CFDs.

For instance, you may believe that the London market will outperform the US market, but be concerned whether there would be a general slump in the world economy. Index CFDs will allow you to trade in line with your sentiment by going long on the FTSE index CFD and short on the Dow Jones index CFD, for example. The result of this is that any time the FTSE index gains relative to the Dow Jones index, you will be in profit. It does not matter whether or not the world economy as a whole suffers a decline (for the purposes of this trade), as you have hedged that element out of your trade by taking the two positions. This is a practical example of pairs trading.

This example serves to emphasize the other advantage of trading CFDs, compared with some other financial instruments. It is just as easy to go short on any CFD as it is to take a long position. In fact, as you receive rather than pay the interest when you have a short position, this is one of the elements of trading CFDs that is better than trading any other type of financial security.