Contracts for difference can be traded on a variety of different markets and underlying bases for investment. But what about less standardised investments? What about situations where no market exists per se, but opportunities for investment arise by virtue of external factors? Indices represent a collection of underlying markets or assets, aggregated to produce a single representative figure on which performance can be tracked, measured and compared against past performance, and on which future movements can be forecast. Obviously not especially relevant in the case of exchange traded CFDs, index-driven contracts for difference tend to be available directly from brokers across a range of popular markets.
What Is An Index?
Another basis for trading CFDs, indices (or index, singular) are effectively notional markets that either aggregate the performance of other markets, or try to factor in other data into a numerical way. For example, CFDs could be bought on UK interest rates with some brokers, which are indexed to allow month on month and year on year comparisons. Or, a trader might invest in the S&P 500 – an index comprised of the aggregate of 500 large US companies. Unlike a market, where there is an underlying asset to be bought and sold, indices normally have no inherent value – they are simply artificially collated pictures of other assets, markets or factors to enable trading on a more widespread basis. Indices are a collection of assets priced up to give a single representative value on which traders can speculate, which enables forecasting to be made on wider economies and sectors without the need to invest in one particular market or asset.
What Is It For?
Imagine you, as a trader, see a glaring opportunity in the UK economy. A culmination of factors has come together to suggest that the UK as a whole will perform well, and the likelihood of a surge in the markets is significant. How best do you capitalise on this opportunity? Indices provide a means in this type of scenario whereby traders can invest more flexibly on markets that wouldn’t otherwise be open to them, for example using the FTSE100 as the basis for speculating as opposed to individual shares. Indices allow traders a heightened degree of flexibility as compared to trading in markets alone, and in the process enable traders to take advantage of the functions of CFDs on a broader range of investable bases.
Why Do Traders Trade Indices?
Indices effectively fill in the blanks where markets leave traders high and dry. Markets tend to be established in only the most direct and in-demand areas, where assets with underlying value can be bought and sold on a primary and secondary (i.e. speculative) basis. Unlike markets, where there are counterparties to both sides of each trade, trading on indices is usually regarded as more a form of investment, and one which can only typically be realised through spread betting, CFDs or through some representative fund. Because there is nothing to buy when trading on an index per se, there is unlikely to be correlative buyers and sellers in sufficient volume to provide the liquidity necessary to make a viable market. As such, indices are only notional, providing a numerical basis to which positions can be pinned, and there is not usually a market in indexed instruments in which traders can invest directly.
This perhaps creates the impression that indices are secondary to markets in terms of trading potential. That couldn’t be further from the case. By providing an additional angle through which traders can speculate on market and economic performance, indices play an important role in giving traders the flexibility to profit from opportunities wherever they happen to arise.
How Are Indices Traded On?
The first main difficulty with trading on an index is that this isn’t usually possible. Indices are notional, rather than markets which are tangible, and they only exist insofar as they are offered by your broker as an investment option. For this reason, indices tend not to be traded on in any cash markets, and are retained as a preserve of certain off-exchange derivatives. That said, there are other ways in which brokers and investors have managed to get around the lack of direct trade in indices. It is commonplace, particularly amongst asset managers and other investment management funds to package specific investment products that represent wider indices – for example, it might be possible to buy into a FTSE100 fund, which is exposed to a basket of shares in the same mix as the FTSE, and effectively acts like buying a share in a company in the sense that the individual investor owns a percentage of the overall fund rather than any specific share or security. While this does provide a solution to the problem of trading on indices, it does little to satisfy the urge of the trader to make quick investment decisions and profit from speculation. So what are the viable alternatives for those looking to scalp a quick profit from an index-based investment?
Why Are CFDs Traded On Indices?
CFDs are predominantly traded on indices as a means of rounding this very issue. Obviously this isn’t their only advantage, but it is a pretty considerable one when it comes to looking at how to trade on indices. CFDs simply offer the proposition that the trader will settle with the broker for the difference in the underlying index price between the start of the trade and the end of the trade, and so becomes the perfect instrument through which to invest in indices. This means in practice that traders anticipating a rise in some index that isn’t neatly represented elsewhere can make price speculations on that basis, without the need to distort their trading behaviour. Rather than having to invest in a number of positions, and to try to artificially represent the relevant index the trader wants to track, CFDs can allow direct investment in a single, albeit artificial, instrument through which they can trade directly on the best basis for their investment.
Of course, aside from the obvious convenience of investing through CFDs, the advantages of mass leverage via margined trading makes it possible not only to speculate, but also to generate considerable returns on positions that otherwise might not even be attainable.
When To Use CFDs To Trade Indices?
CFDs are almost always a good way to trade indices, because they afford the flexibility of being able to reach those investments that markets can’t provide for while also introducing the massive benefits of margin trading. The question really is how do you best define when indices represent a valid alternative to trading in the markets more directly, and there are a number of circumstances where this is the case. Generally speaking, indices represent an alternative, more general picture of a particular sector, economy or government than individual markets will allow. This opens up indices to momentum traders, and those that make investment decisions on the basis of current affairs and news events. For example, if you suspect the German economy to perform well in the next 24 hours, a CFD that incorporates the DAX represents a quick, one-instrument investment to represent the aggregated value of a number of DAX stocks. In its simplest package, the CFD here allows you to speculate on the performance of the German economy as a wider entity, as demonstrated through the DAX, which would otherwise not be possible.
Indices play a central role in the life of the CFD and derivatives trader, and for all intents and purposes, they make no real practical difference to markets in terms of how the transaction is carried out. While their differences are substantial and technical in nature, trading indices through CFDs can actually be advantageous as compared to trading in baskets of shares, or trading more narrowly in specific industries you have forecast to perform well in connection with the wider economy.