By using a CFD, a trader can trade stock indices without actually owning the stocks in the index. For example, instead of buying all 30 stocks in the Dow Jones Industrial Average, a trader could buy a CFD based on the Wall Street 30. In addition, they may bank on the index going down, not just up.

Reminder: What is a stock index?

A stock index is a collection of different stocks that are grouped together based on where they are traded, what industry they represent, and so forth. An average price is continually calculated for all the stocks in the index, which creates the value of the index. The best-known stock indices, like the Dow Jones and S&P 500, are also called as stock averages for obvious reasons.

The original index was the Dow Jones, which simply consisted of the shares of the 30 biggest industrial companies in America. Today, every country has a benchmark stock index, considered the go-to indicator for judging that country’s market and overall economic performance. 

And what is a CFD?

CFDs (which stand for Contracts For Difference) reflect the price movement of an underlying asset. In this sense, they are similar to futures contracts, though when trading a CFD, you never own the underlying asset. The idea is simply to speculate on the price movement of some financial instrument. In this article, we talk specifically about index CFDs, but CFDs come in many flavours depending on which asset class is involved: forex markets, commodities, or cryptocurrencies, to give some exampeles.

What are the most popular index CFDs?

Here are the most widely-watched global indices and their CFD equivalents:

The math behind indices

Fortunately, individual traders needn’t calculate the value of any index because these are widely published on the internet. Almost certainly, your favourite online trading platform streams these in real time and allows you to set alerts based on rules you specify. Still, it’s useful to understand what it is you are actually trading because the way an index is set up will determine how market changes affect its value. 

By convention, every index starts with a value of 100 when it is created. The return on each stock is calculated on a daily (and even intraday) basis and then averaged to give a return for the index as a whole. The next day, the returns are added to the new index value. Historically, stock markets rise in value over time and so end up with values that are many multiples of 100.

There are three main ways a stock index is calculated, and they vary based on which shares within the index are given more or less weighting. A stock with a larger weighting in the index will affect the value of the index 

Equal-weighted method

This is probably the least common, but it does have the virtue of simplicity. Each stock in the index is given an equal weight, no matter how big the company is or how often it’s been mentioned in recent news. The return of each stock is added up and divided by the number of stocks, and that gives you the return of the index.

Market-capitalisation method

The idea here is to acknowledge that bigger companies should have a correspondingly bigger impact on the index than smaller ones. This does make intuitive sense, because the larger companies tend to earn more profit, hire more employees, etc., making them more important to the market. Each stock in the index is weighted based on the market capitalisation of the company (market cap means the share price times the number of shares). Most global indices, including the S&P 500 and SMI, are market-cap weighted.

Price-weighted method

In this method, more importance is attached to the share price than to the market cap of the companies in the index. As such, stocks with a higher share price have a larger weighting than those with a smaller price. Accordingly, the index’s return reflects that of a portfolio containing one share each of its constituent stocks. The Dow Jones Industrial Average is price-weighted.

Where does the index CFD price come from?

It’s important to understand that the index itself is purely a mathematical construct and cannot be traded. The main alternatives to using an index CFD are buying all the individual shares in the index, trading index futures, or investing in an index ETF.

Index futures

Index CFDs typically use an index futures contract as the underlying asset. CFD brokers will typically offer front-month and future-month contracts, in which case prices closely resemble the underlying market. In these instances, the index CFD will expire just before the underlying futures instrument expires. 

Cash indices

The second, and typically more popular, option is to trade a rolling “cash contract”, where the aim is to use the futures contract to construct what the real cash value of the index is, adjusting for things like interest rates and fair value. The advantage of this approach is that the CFD will automatically roll over from one month to the next and never expire.

Why traders choose index CFDs

• Automatic diversification
• Convenience
• Low cost
• Possibility of shorting the index
• Leveraged trading available
• Easy to hedge an equity portfolio

Buying or selling an index gives you exposure to an entire stock market or sector with just one trading position. This kind of diversification would be costly and hard to implement in a portfolio with purely individual stocks. Each stock would need to be purchased, which means paying a corresponding commission and, if your goal was to be true to the index, the weightings would need to be calculated too. 

One of the main drawbacks of restricting yourself to trading index CFDs is that it can cause you to overlook more granular opportunities. If, for example, you feel confident that the Swiss economy will do well and Swiss companies will therefore improve their profits overall, buying the SMI index would be an appropriate trade. However, if you had done some research and believed a new drug produced by Swiss pharmaceutical company Roche would improve Roche’s earnings, it would be more appropriate to buy Roche shares in particular rather than the SMI index as a whole.

Index CFDs are typically traded commission-free with all fees incorporated into the bid-ask spread. This can make a large difference if you trade positions frequently.

Another popular use of CFDs is to short the market – bet that it will fall. Borrowing real shares and going short on individual stocks can be cumbersome, while the process and cost involved in shorting an index CFD is no different from taking a long position. 

Index CFDs are typically traded using leverage, meaning the holder of the CFD only needs to commit a small initial deposit (known as the margin) to initiate the trade. Using margin amplifies potential profits but equally magnifies losses. Though many brokers and trading platforms offer leverage, it shouldn’t be abused.

The ability to go short is especially useful if you want to hedge an existing portfolio using the index. For example, let’s say a Swiss investor has a portfolio of 10 Swiss stocks but feels the overall Swiss stock market has gotten a bit over-extended and may be due for a correction. They can then retain those shares but also sell the SMI index CFD short, which will offset any losses caused by shares losing value. 

Getting started trading index CFDs

Picking individual stocks is labour-intensive: reading earnings reports, analysts’ opinions, and industry news takes quite a bit of time. Investing in an index is simple and worry-free by comparison. It’s worth noting that CFDs, unlike stocks, are usually short-term investments. If this isn’t a drawback for you, though, there’s nothing stopping you from logging into your trading app today and betting on whether some stock market is likely to grow or decline.