Index CFDs

What the contract references 

An index is a published number. It is calculated by an index provider from the prices of a defined list of listed companies, according to a rule the provider writes down and applies mechanically, and it is republished continuously through the trading day of the exchange whose shares it covers. The number has no intrinsic unit. It is not a currency amount and it is not a price at which anything can be bought, because nothing that trades is called by that name. It is a summary statistic, and its only job is to be comparable with the same statistic calculated yesterday.

An index CFD is a contract written on that published number. Two parties agree a level, agree a money amount per index point, and agree that when the contract ends the difference between the closing level and the opening level will be multiplied by that money amount and settled in cash. Nothing is delivered, no share is bought, and no entry appears on any company's share register. The contract borrows the index provider's arithmetic and converts a unit-less statistic into an amount of money.

That conversion is the whole instrument, and it explains the class in one line: an index CFD is a way of taking a position on the aggregate direction of a national or regional stock market without dealing in any of the companies inside it. The distinction matters because the aggregate behaves differently from its parts. A single company can fall on its own accounting; an index built from hundreds of them mostly cannot, because the idiosyncratic movements of individual constituents partially cancel and what remains is the part they share.

Who trades index markets 

The participants divide into groups with genuinely different motives, and the price at any moment is the residue of all of them acting at once.

• Institutional hedgers. A fund holding a portfolio of shares carries exposure to the market as a whole as well as to its own selections. Selling an index derivative removes part of the first without disturbing the second, which is cheaper and faster than liquidating the portfolio and rebuying it later.
• Asset allocators. Pension funds, insurers and sovereign investors move capital between whole markets rather than between individual companies, and an index derivative is the instrument that expresses that decision directly.
• Market makers and arbitrageurs. The relationship between an index derivative and the basket of shares underneath it is arithmetic, so a gap between the two invites a trade that closes it. This activity is the main reason a derivative on an index tracks the index rather than drifting away from it.
• Index funds and exchange traded funds. These are not usually trading the derivative, but their scheduled buying and selling around index reviews is one of the largest predictable flows in the market, and it acts on the constituents rather than on the index number.
• Retail traders, through CFDs and through exchange traded derivatives, generally taking directional positions on a market they can describe in one sentence.

The instruments in the class 

Index CFDs are conventionally named for the market they cover and the number of constituents in the underlying benchmark rather than for the benchmark's registered name. The North American contracts are Wall Street 30, US 500, US Tech 100 and US Small Cap 2000. The European set runs Germany 40, UK 100, France 40, Euro 50, Spain 35, Italy 40, Netherlands 25, Switzerland 20, Sweden 30 and Poland 20. The Asia Pacific set runs Japan 225, Hong Kong 50, China A50, Australia 200, Singapore 30, Taiwan Index and Korea 200. Beyond the developed markets sit India 50, South Africa 40 and Turkey 30.

Two instruments in the class are not equity indices at all and are grouped here only because they are quoted as index levels. The US Dollar Index measures one currency against a basket of others. The Volatility Index measures the volatility the options market is pricing into a large United States equity benchmark over the coming month, which makes it a measure of expected turbulence rather than of direction.

Cash contracts and futures based contracts 

Index CFDs come in two constructions and the difference is visible in the contract specification rather than in the chart. A cash index CFD, sometimes called a spot index, has no expiry. It stays open until it is closed, and because it is not funded in full it carries a financing adjustment for every day it is held past the daily cut. A futures based index CFD takes its price from a listed futures contract, inherits that contract's expiry, and is closed or rolled on a published date rather than on a date either party chooses.

The two constructions price differently for a structural reason rather than an accidental one. A futures price embeds the cost of carrying the underlying basket to expiry and the dividends that basket is expected to pay before then, so a futures based contract and a cash contract on the same index are rarely quoted at the same level, and the gap between them narrows as expiry approaches. Neither is more correct. They are answers to different questions, and a contract specification states which one an instrument is.

When index markets trade 

The underlying index is only calculated while the exchange behind it is open, because it is computed from live constituent prices. The derivative, however, is quoted for far longer. Index CFDs are typically available around the clock on weekdays with a short daily break, so for most of the day a contract on a European or Asian index is trading while the shares underneath it are not.

That gap is the single most misread feature of the class. Outside the cash session there is no constituent price to compute an index from, so the quoted level is derived from the related futures market and from correlated markets that are open, and it can move a long way from the last cash close before the exchange reopens. This is also why the class gaps. An index that closed at one level can reopen at another with no trading in between, and any level between the two never existed as a quotation.

How an index CFD settles 

Settlement is arithmetic. The difference between the closing level and the opening level is taken in index points, and each point is worth the money amount stated in the contract specification for that instrument. The result is a cash amount, and it carries a sign that depends on which side of the contract is being calculated. Nothing else settles: there is no basket of shares to deliver and no entitlement to anything the constituent companies distribute.

The second calculation the class requires is currency. An index is denominated in the currency of the market it covers, so a contract on a European or Asian index produces a result in that currency and is converted into the account currency at the prevailing rate. The conversion is a second exposure, small relative to the position but real, and it exists whether or not it is noticed.

The third is margin. An index CFD is not funded in full. A percentage of the contract value is posted as a margin requirement and held for as long as the contract is open, while the settlement arithmetic above is calculated on the whole contract value. Because the multiplication runs on the full value rather than on the sum posted, an adverse movement is not bounded by the margin, and a loss can exceed it. A favourable movement is calculated on exactly the same basis and to exactly the same degree.

Index CFDs at YAL are traded on MetaTrader 5, and each instrument's point value, margin requirement, trading hours and construction are published in its own contract specification rather than being uniform across the class.

What the class does not give 

Three absences are worth stating plainly, because each one is occasionally assumed. An index CFD confers no ownership of the constituent companies, so it carries no vote and no place on any register. It confers no entitlement to dividends, although a cash adjustment is conventionally applied when a constituent goes ex dividend so that the contract is not distorted by the mechanical fall in the index that follows. And it confers no protection from the concentration inside the index: a benchmark dominated by a handful of very large companies transmits their movements to the whole contract, which is a property of the weighting rule rather than of the derivative.