Indices
An index combines many shares into a single number, the DAX for example the forty largest German companies. Owning it through an ETF and trading it through a CFD or future are two very different things with very different risk.
An index like the DAX or the S&P 500 isn't a product itself. It's a calculated number, a basket of shares combined into a single value. The DAX represents the forty largest German companies, the S&P 500 the five hundred largest American ones.
If the DAX rises one percent in a day, the forty companies in it are worth one percent more combined. Individual shares can still fall that day if others rise by more. Indices is simply the plural of index.
You can't buy an index directly. There are two very different ways to get close to it. The first is an ETF on the index that actually holds or replicates the shares in it. That makes you an economic part owner of all these companies, and the money is protected as a segregated fund.
The second is a CFD or future on the index. That's a pure bet on the index level, usually with leverage, and none of it belongs to you. Your counterparty is the provider, not a portfolio full of shares.
In everyday life the two are often confused, yet they have little in common. One is investing with a long breath. The other is trading with all the risks that come with it, up to liquidation. If Tim buys a DAX ETF for €5,000 and the DAX falls 20 percent, he has a €1,000 paper loss and waits. If he holds the same bet as a CFD with leverage 5, his stake is gone.
Most big indices weight their companies by market value. The bigger a company, the more it determines how the whole index moves. In highly concentrated indices a few giants therefore make up a large part of the movement, and the spread across “500 companies” is smaller in practice than it sounds. In the S&P 500 the ten largest companies now make up over a third. The Dow Jones is a historical exception: it weights by share price rather than market value. Methodologically that makes little sense, but out of tradition it's still widely watched.
CFDs and futures on indices don't cost exactly the same as the index. They trade at a premium or discount that includes expected dividends and financing costs, among other things. For futures this difference is called the basis, and it disappears on the expiry date. With index CFDs, as with forex and perpetuals, financing costs are charged every night. If you hold a leveraged position for a long time, that makes it noticeably more expensive.
Often overlooked is that indices are regularly reshuffled. Companies drop out, others come in. An ETF replicating the index then has to rebalance, and that costs trading fees. Its performance therefore deviates slightly, but always in the same direction, from the pure index calculation.
Summary
- An index is a calculated number, not a product you can buy directly.
- With an ETF you own the shares, with a CFD or future you bet on the price with leverage.
- Because weighting is by market value, a few giants determine a large part of the index.
Did you get it?
Can you buy an index directly?
No. Either you replicate it with an ETF that really holds the shares, or you bet on its level with a CFD or future without owning the shares.
What's the key difference between an ETF and an index CFD?
The ETF belongs to you and is protected as a segregated fund. The CFD is a contract with the provider, usually leveraged and with ongoing financing costs.
Why do individual indices move so differently in size?
Because of the weighting. With weighting by market value, a few very large companies determine a large part of the movement.
What is an index, in simple terms?
A number that combines the value of many shares. The DAX, for example, shows how the forty largest German companies are doing together.
How can you trade indices?
Long term through an ETF that holds the shares in the index. Short term through CFDs or futures, usually with leverage and ongoing costs. For beginners the ETF is by far the lower risk route.
Check your understanding
Related
- What an ETF isStage 1
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- DiversificationStage 3