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The facts behind trading indices (In this morning's CityAM)

AFTER trading individual equities, retail traders are usually inclined to dabble in trading their indices. So what is an equity index, how are they priced and what are they actually trading?

An equity index is a benchmark value of a basket of stocks. Each index will clearly define what its constituents are and how it is calculated. The most popular equity indices receive considerable coverage within the media, especially when they can easily summarise a country’s economy, or a downturn in the market – such as the Ibex 35’s 20 per cent decline in 2012.

Trading indices as a whole, rather than individual equities enables a trader to speculate on the performance of the entire benchmark. Equity indices allow a trader to take a broader view of the group of companies, reducing the risk of trading individual companies. By trading global equity indices, a trader is able to geographically diversify his or her portfolio and potentially profit from the growth or contraction around the globe. Major indices are commonly used as the benchmark to measure the performance of portfolios.

The Structural basis

Many retail traders do not realise that you cannot easily trade the cash price you see published within the paper or online, as it is simply a calculated benchmark; therefore, trading is done through derivatives. These are mostly futures based (usually exchange based), or via over-the-counter (OTC) derivatives such as a contract for difference (CFD). It is important to note that when trading equity indices it is not possible to take ownership of the underlying assets.

Not all CFD products are the same. The largest difference is whether the CFD is based on an underlying future, or the cash index, which may well be internally priced if traded through a market maker (future price – the fair value = cash price).

It is possible to trade equity indices when the cash market is closed due to the futures market being open and/or the willingness of market makers to internally price a product. As many individual traders have other commitments, this can be highly convenient.

As an example, a market maker may well price its FTSE 100 cash overnight by following the S&P 500’s volatility. CFDs are traded on margin, such as 1.5 per cent of the full value, and this is an economical way to diversify an investment portfolio and gain exposure to a group of equities. However, if you are paying a financing fee then any positions that are held long term may well see the profits eaten in to due to the high leverage (which incurs a high cost from the market maker).

Market gaps are an issue when trading cash equities as it is possible to see a large market gap on the open of an index. This is generally seen within European markets following a large directional move in the US or Asian sessions.

CFDs are OTC derivatives and aren’t suitable for all investors. However, they allow traders to go long or short without restrictions and benefit from the volatility of the index. CFDs are intended to mirror the underlying market without the associated costs of clearing and associated commissions.

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