Choosing a market for CFD trading

Lesson 3 of 6

Trading CFDs on stock indices

As a stock index is essentially just a benchmark number representing a group of shares, you can't buy or sell it directly on an exchange (known as the cash market). You could of course trade each of the individual constituent stocks in their relevant weightings, but this would be a complex and inefficient process.

So the practical way to trade stock indices is via derivative futures contracts, bought through a bank or futures broker, or other derivative products like CFDs.

Did you know?

Derivative products are so-called because they derive their value from an underlying asset, such as a stock index.
A derivative stock index futures contract is a basket of all the constituent stocks on an index, and is traded on a regulated exchange. For example, FTSE 100 futures trade on the Intercontinental Exchange (ICE).
The prices at which you buy or sell the futures contract are effectively the aggregated buying or selling prices for the underlying constituent shares. Every futures contract has an expiry date, and the value of the shares between today and the expiry date could change due to the effects of interest and any dividend payments. Taking into account these factors can cause futures prices to vary from the present value of the underlying index.

CFD providers create their own stock index markets with prices derived directly from the futures market for each underlying index. You’ll notice that CFD markets usually have different names to the underlying indices. This is because the actual stock indices are calculated, owned and trademarked by various organisations – for example, the Dow Jones Industrial Average is owned by S&P Dow Jones Indices, while the German DAX is operated by Deutsche Börse – so their names can’t be used.

Here’s an example of a few of the markets IG Bank offers:

Underlying index IG's market
S&P 500 US 500
NASDAQ-100 Tech 500
Dow Jones Wall Street
CAC 40 France 40
DAX 30 Germany 30
ASX 200 Australia 200
Nikkei 225 Japan 225
FTSE 100 FTSE 100*

*IG has special dispensation to use the FTSE 100 name. Most other providers call this the 'UK 100' or similar.

CFD prices

Unlike shares, forex or commodities, there are no direct buy or sell prices for underlying stock indices. Each index has a unique value which is calculated on an ongoing basis. Your CFD provider’s buy and sell prices will generally be wrapped around this value, but being based on the futures market they may not be aligned precisely with it.

For example, say the NASDAQ-100 June futures market is at 4600, and your provider is offering a two-point spread on its version of this market. This means it will add a spread of one point either side of the current value to create a price of 4599/4601.

Question

The DAX 30 September futures market is currently trading at a value of 9398.5. Your provider is offering a four-point spread on the market. What will its sell price be?
  • a 9394.5
  • b 9396.5
  • c 9400.5
  • d 9402.5

Correct

Incorrect

A four-point spread means the 'buy' price will be two points above the DAX's current market value, while the 'sell' price will be two points below.
Reveal answer

Out-of-hours pricing

The value of an actual stock index doesn't change when the underlying market is closed. For example, the London Stock Exchange is open from 9:00am to 5:30pm (Swiss time) from Monday to Friday, and outside of these times the FTSE 100 doesn't move as none of its constituent stocks are being traded.

However, the underlying futures market is open longer: for example, FTSE futures trade from 02:00 to 22:00. So futures prices move with fluctuations in supply and demand while the stock exchange is closed, and so do the CFD prices derived from them.

Of course, there are still periods when both the stock and futures markets are closed (four hours in the case of the FTSE). You may be surprised to learn that some CFD providers are nevertheless able to offer prices for their clients to deal on during these times.

To do this they use the performance of other markets around the world – generally other stock indices – to predict how that index should be priced. By applying a mathematical formula to these related markets, providers can derive a ‘buy’ and ‘sell’ price for the closed index. These prices will also fluctuate based on the business that the provider receives while the underlying market is closed, as well as any news events that could influence the index concerned.

It’s important to remember that these out-of-hours prices can be very different to those that will be available when the market next opens. So although out-of-hours dealing enables you to capitalise on opportunities while markets are closed, there’s also the risk of incurring a loss that would have been avoided if you had waited.

In addition, since there’s no market available to validate out-of-hours prices, you’ll find that most providers offer wider spreads during these periods. This gives them a better chance of reflecting the underlying index level accurately in their pricing.

Here are the typical spreads offered by IG Bank at different times on the FTSE 100 cash CFD market:

Time period Dealing spread
02:00-08:00 3
08:00-09:00 2
09:00-17:30 ('in hours') 1
17:30-22:00 2
22:00-02:00 4

Impact of leverage

When you trade CFDs on stock indices, you'll need to put up a margin payment which may only be a small proportion of the value of your position. Remember that your potential loss could be much greater than this, however.

Lesson summary

  • Because indices are essentially just numbers that can’t be bought or exchanged, you can’t trade them in the traditional way
  • CFD providers enable you to speculate on indices by providing their own markets which ‘shadow’ the underlying index value
  • Buy and sell prices for indices are created by wrapping a spread around the value of the index
  • Some providers offer CFD trading on indices outside of market hours, generally with wider spreads at these times
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