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GUIDE | TRADING BASICS | BEGINNER

How to trade index CFDs

Learn the basics of trading index CFDS, including what they are, how they work, and why traders love them!

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Key takeaways

Index CFDs are a quick, convenient, and cost-effective way to trade an overall market.

Index CFDs are ideal for diversification and risk distribution offering exposure to a range of assets across a specific sector or an entire economy in a single trade.

You can enter both ‘long’ (buy) and ‘short’ (sell) positions to maximise opportunities for returns.

Margin and leverage in Index CFD trading means you need less capital for large trades.

Like all leveraged products, Index CFDs are complex instruments and come with a high risk of losing money rapidly.

What are Index CFDs?

To define Index CFDs, let us first consider their two parts individually: indices and CFDs.

Indices

Indices, also known as indexes, are financial instruments that represent a collection or portfolio of related assets, such as stocks from various companies. Imagine an index as a virtual basket that holds a variety of assets rather than relying on just one specific asset. Instead of following the performance of a single company's stock, the index "tracks" or measures the overall performance of the entire group of assets it represents. The assets are grouped together based on certain criteria such as prominent national companies, a specific sector or an entire economy. For example, the well-known S&P 500 (SPX500) comprises 500 of the largest companies listed on US stock exchanges.

Mini indices provide the same exposure as the main index but offer smaller lot sizes, so they cost less than their 'major' counterparts. Minis are a great option for new or cautious traders to 'test the waters' of trading Index CFDs with less capital. It's easy to spot a mini index with FXTM, as they have an '_m' at the end of their name. For example, the mini version for the S&P 500 is SPX500_m.

CFDs

CFDs is the abbreviation for Contract for Difference, a form of derivative trading. A derivative is a financial contract between two parties that takes its value from the price of an underlying asset, like the indices.

Essentially a CFD allows you to speculate and potentially profit from changes in the asset’s price - both increases and decreases, depending on your position - without owning the asset itself.

Index CFDs are a form of derivative trading specifically for indices, which track the overall performance of a collection of stocks and not an individual asset or commodity.

How are indices weighted and valued?

The value of an index is calculated based on its weighting.

The type of weighting is usually determined by the index’s managing company. Two weighting methodologies commonly used are price and capitalisation. Let’s start with price.

ABC example index table

Price-weighted index

In a price-weighted index, each company's stock is weighted by its price per share, and the index value is an average of the share prices of all the companies. The higher the price of a stock, the greater the weighting of that stock within the index.

For example, let’s imagine there’s a stock index called ABC Index and it’s comprised of 5 companies with the following names and share prices.

To calculate the index value, we add all the share prices together and divide by the number of companies included in the index.

Because Business B has the highest share price, it has a greater weighting than Company A and Corporation C. This means that any movement in the share price of Business B will have a greater impact on the overall index value than changes in the share prices of Company A or Corporation C.

The Dow Jones and the Nikkei are examples of price-weighted indices.

Capitalisation-weighted index

In a capitalisation-weighted index, also known as cap-weighted, the stocks are weighted relative to each company's market capitalisation, or market cap.

The total number of outstanding shares is multiplied by the market price to calculate market cap. The index is then weighted proportionally to each stock’s market cap as a percentage of the total market cap of all included stocks.

Let’s look at our example of the imaginary ABC Index again. This time, the companies are listed with their outstanding shares and market price.

In this instance, Corporation C has the highest weighting as it has the highest market cap of the companies included within the index, despite a lower price per share. A change in the market share price for Corporation C would have a bigger impact on the index's performance compared a change in any of the others.

The S&P 500 and the Nasdaq are examples of cap-weighted indices.

ABC example index table

Benefits of trading Index CFDs

Flexibility

Arguably one of the primary benefits of trading indices CFDs is the ability to profit from both rising and falling markets.

With CFDs, you can take long (buy) or short (sell) positions, allowing you to potentially benefit from both upward and downward price movement.

Whatever direction the markets are heading, CFD indices always provide opportunity.

Leverage and margin

A key advantage of trading CFDs is that you only need to deposit a small percentage of the total trade value, known as margin.

Unlike traditional stock trading, where you’d need to own the physical shares, CFDs allow you to speculate on indices without owning the underlying assets.

Using margin gives you greater exposure to the market because profits and losses will be calculated based on the full position size, not only the funds used as margin.

Let’s say you wanted to buy $100 worth of stocks. Typically, you’d have to pay $100 for the asset. But if you had a leverage of 10:1, for example, you’d only have to place 10% of your total trade value down as capital, in this case being $10. So, you still have the advantage of the higher trade value, but with less capital required.

Leverage is higher with indices CFDs than with traditional trading

Using a smaller portion of your capital when opening a position allows for potentially greater returns. The crucial aspect to remember is that leverage carries equal risk to amplify losses. As such, it’s essential to understand the risks of margin and leverage and apply effective risk management strategies to prevent significant losses.

Risks of trading Index CFDs

How do Index CFDs work?

Engaging in a contract

The CFD contract is an agreement between two parties – the trader, or ‘buyer’ and the broker, or ‘seller’. As the trader, you’ll need to decide which index to trade and whether you think the price will increase or decrease. If you think the price will go up, you’d open a long position (buy), or if you think it will fall, you’d open a short position.

How does the contract work?

As its name suggests, the contract is concerned with the difference in price. Specifically, it looks at the difference in price from when the contract is entered to when it’s exited. If your position was correct, you’d profit, and the ‘seller’ who entered the contract with you would pay you, the ‘buyer’, the difference in the price between entering and exiting prices. If, however, your position was incorrect, you’d be at a loss, having to pay the ‘seller’ the difference in price.

Calculating contract profit or loss

The key calculation to work out your profit or loss is the difference between the price at which you enter and the price when you exit, multiplied by your number of CFD units.

Calculation examples don’t take into account spreads, commissions, or swap rates.

Indices Explanation Image

Example of profit in a ‘long’ (buy) trade for the NQ100_m.

What happened:

  • Market entered at 13300
  • Stop loss set at 13000 (not triggered)
  • Take profit triggered at 14300
CFDs Explanation Image

Example of loss result in a ‘short’ (sell) trade for the SPX500_m.

What happened:

  • Market entered at 4200
  • Take profit set at 4140 (not triggered)
  • Stop loss triggered at 4238

FREQUENTLY ASKED QUESTIONS

Investor sentiment and market expectations play a significant role in the price movement of indices CFDs. Positive sentiment can drive prices up, while negative sentiment can lead to declines.

Economic indicators, such as USD growth, inflation rates, employment data, and central bank decisions, can impact index prices. Strong economic data may lead to higher index prices, indicating a robust economy, while weak data may result in lower prices.

You can see a comprehensive list of upcoming events and data releases using the FXTM economic calendar.

The financial performance of companies within the index can affect the index price. Positive earnings reports and outlooks from constituent companies often lead to index gains, while disappointing earnings can cause declines.

Changes in interest rates set by central banks can impact index prices. Lower interest rates generally encourage investment and can drive index prices higher, while higher rates can have the opposite effect.

Geopolitical developments, such as trade wars, political instability, or international conflicts, can create volatility in the markets and affect index prices. Uncertainty and negative news can lead to price declines, while positive resolutions can have the opposite effect.

The level of liquidity in the market, including trading volumes and spreads, can influence index prices. Higher liquidity generally leads to smoother price movements, while lower liquidity can result in more significant price swings and volatility.

Specific sectors within an index can experience unique factors that influence their performance. For example, regulatory changes, technological advancements, or supply and demand dynamics can impact certain sectors, affecting the overall index price.

How to trade Index CFDs on FXTM

FREQUENTLY ASKED QUESTIONS

An index measures the collective price performance of a group of shares, usually from a particular country. Indices are often used to track and compare the performance of stock markets. The performance of each index is dictated by the performance of the underlying share prices that make up that index. An index is constructed and calculated independently, sometimes by a bank or by a specialist index provider like the FTSE Group. The choice of the companies included in the index is determined by index calculation rules or by a committee. Not all indices use the same rules, however.

By using a CFD, or contract for difference, for indices trading, traders can profit from whenever prices either rise or fall. Traders can accomplish this by either opening a short (sell) or long (buy) position, depending on whether they think the index will fall or rise, respectively.

The biggest difference between Index CFDs and shares is that CFDs are contracts for differences, not a physical asset. This means that you can speculate on the market without needing to physically own the shares that the CFD reflects. Owning shares, on the other hand, means you take a varying level of legal ownership in those company assets.