At the height of the global financial crisis, CFD traders made a big migration. From individual stock CFDs, they moved to index CFDs; and later, to currency CFDs.

The move to index CFDs came because “people could see that the indices traded 24 hours, instead of 10 am–4 pm for shares,” says Kara Ordway, senior market maker at City Index.

“That had big appeal, you can get in and out very easily, you’re not at risk of having a small amount of volume in that particular stock you're trading. There is always a fair amount of volume going through the indices, it’s very liquid, and also people saw that the indices were capturing bigger moves.”

Over the past six months, says Ordway, about 65 per cent of her firm’s trades have been in index CFDs. “That’s across all indices, US or European or Australian or otherwise,” she says.

Index CFDs is a category of CFDs that relies wholly on market-makers, who create clones of the major indices, and quote a spread on each. (They cannot use the actual indices, which are usually trademarked, for example the S&P/ASX 200.) Index CFDs are commission-free, and you can trade for $1 a point.

Index CFDs generally trade around the clock during the week, although they shut down over the weekend. The CFD providers will mostly offer a continuous price as many of them base their price feeds on the futures products that mirror these indices. About 25 indices are offered, including US sectoral and capitalisation-specific indices.  

CFD providers normally charge a premium for holding the positions overnight and this figure can run as high as plus or minus 4 per cent – which can add up very quickly, especially on large position sizes.

Depending on your trading strategy, you can choose between CFDs biased to either the underlying cash markets or futures markets. Cash index CFDs have no pre-defined expiry date, while index futures CFDs can be ‘rolled-over,’ and thus are favoured for longer-term trades.

“Most index clients have a directional view on the market, and they want to take a position on that,” says Ordway. “They like the fact that they are able to trade on a more ‘macro’ economic level, and they don’t have the exposure to individual company risk that they have when trading equity CFDs.”

Because of the greater liquidity involved in index CFDs, the providers offer much more leverage than equity CFDs. Margins are usually 1 per cent but in in some cases can be as low as 0.25 per cent for the major indices – meaning 400 per cent leverage.

Index CFDs are also used for hedging purposes, says Ordway. “Occasionally traders will take a short position against the ASX 200 as some protection against a fall in their stock portfolio of stock. If they went stock by stock, they could get a perfect hedge, but doing it through the index CFD is a quick way to get an approximate hedge,” she says.

Chris Weston, head of sales and research at IG Markets, says the “overwhelming bulk of use” of index CFDs is for speculation. “That’s the vast majority of activity, people taking a view on an individual market – through either a fundamental or a technical reason – and expressing a view on the direction of the index.”

But Weston says many of the “more savvy” clients are using index CFDs in a ‘pairs trade,’ taking simultaneous long/short positions to play the relative attractiveness of indices. In a pairs trade, it does not matter if the markets are rising or falling, just that the ‘long’ side outperforms the ‘short’ side of the trade.

“At the moment, the US markets are looking a bit tired, and investors have been prepared to back the Australian and Japanese markets to outperform the US market. They’ve been buying the ASX 200 cash CFD or the Nikkei 225 CFD, and shorting either the S&P 500 CFD, or the Dow Jones CFD.”

The disappointing third-quarter earnings season in the US, the petering out of the latest ‘liquidity rally’ following the Federal Reserve meeting in September, the imminent election and the looming ‘fiscal cliff’ are all factors in the US markets’ downturn, says Weston.

“Third-quarter earnings were pretty weak, especially when you look at the amount of companies failing to match revenue expectations. There are a few US-centric issues that are worrying the US markets, and they seem to lack a catalyst to push them higher.”

In contrast, he says, both the S&P/ASX 200 and the Nikkei “seem to want to go higher.”

“With the US$/yen rate pushing through 80, the Japanese exporters start to improve their profitably significantly,” says Weston. “Sony, Nissan, Toyota – they all have a lot of upside to a weaker yen, and the Nikkei is very sensitive to that. It looks like it wants to go higher, so that long Nikkei/short S&P 500 just looks like a really clever trade at the moment.

“I wouldn’t say that this kind of pairs trading is really prominent at a retail level, but a lot of hedge funds and active traders do it, because it is just a really interesting way of trading tactically from a very fundamental perspective,” says Weston.

>> Click here to read other articles from this week's newsletter