Spread Betting Indices | Betting on Stock Market Indices

This tutorial is aimed at newbies who want to spread bet on shares and share indices. Indices have always proved popular with traders and typically account for over 50% of trading volumes at spread betting providers with the FTSE 100, Dow and Germany’s Dax accounting for the bulk of the activity.

If you already make money from spread betting you might want to take a look at the indices, one the main advantages of spread betting an index being that it will never go bust or be taken over. Spread betting on indices allows you to trade with much smaller stakes than would be possible if taking the direct route of trading the futures markets, also since all spreadbets are denominated in sterling you do not have any currency fluctuations issues to worry about.

Trading the Indices

What is an Index?

Since you were knee-high to a grasshopper you’ve probably heard disinterested news readers ending their radio programmes with “In financial news the FTSE closed thirty points up. Now over to Julia for the weather”. Terms like the FTSE and the Dow can become very familiar without anyone really understanding what they are. So, here goes.

An Index can be defined either by what it is or what it does. It is a “basket of stocks”, but that’s about as enlightening as a set of flat-pack furniture instructions…written in Korean. What it does is let people see how well a stock market is performing.

While seeing how a stock market is doing can be interesting in itself the reason most people watch indices is to have something to rate their fund manager’s performance against. In other words if the market rises 10% in a year and your fund manager only gets 8% then go get a big stick and beat him. Or, if the market performs 10% and your fund makes 13% then consider throwing another few million (or whatever small change you have lying around) in his direction. And if you happen to be your own fund manager I guess either some self-flagellation or else treating yourself to a great night out is in order (if the two are the same thing…let’s not go there!)

Each index contains of a number of stocks (hence the ‘basket’ analogy). Common ones are:

• FTSE 100: contains stocks of the 100 largest companies quoted on the London Stock Exchange
• FTSE 350: contains stocks of the 350 largest companies quoted on the London Stock Exchange
• FTSE 250: which are the companies listed in the FTSE 350 but not the FTSE 100 … ie companies that are large but not large enough to make the top 100
• ISEQ: contains stocks of the 60 or so companies listed on the Irish Stock exchange
• DAX 30: contains stocks of the 30 largest German companies
• Dow Jones Industrial Average: The ‘Dow’ contains stocks of the 30 largest US companies. The word ‘Industrial’ here is a red herring; the index contains stocks such as Microsoft and Walt Disney which have zilch to do with ‘heavy industry’
• Standard & Poors 500: contains stocks of the 500 largest US companies
• Nasdaq 100: contains stocks of the 100 largest companies on the Nasdaq Stock Exchange. Nasdaq has generally attracted technology stocks so the index has become a proxy for technology companies
• Hang Seng Index: a market capitalization-weighted index of forty-nine companies that are traded on the Hong Kong Exchange.
• Nikkei 225: sometimes referred to as the Nikkei-225 or N-225. It includes 225 companies listed on the Tokyo Stock Exchange.

Spread Betting Indices by CMC Markets

Some Vaguely Interesting History Stuff

It feels like the FTSE 100 has been with us since forever. However it only started life in 1984 with a value of 1000. The FTSE 100 is just a wee bairn compared to the grand daddy of all indices, the Dow Jones Industrial Average. That venerable old-timer was started by the then editor of the Wall Street Journal, Charles Dow, way back in 1896. He used it to help him develop his nascent ideas on Technical Analysis. So if you ever get a Trivial Pursuits question on indices, now you know.

The Fall And Rise Of…An Index

The amount an index rises or falls each day depends on what has happened to its constituent stocks. So for example if an index has an opening value of 100 and during that day the constituents have “on average” gone up 2% then the index value at that day’s close of play will be 102.

Just a little subnote: every number needs a unit. So share price changes are measured in cents or pennies and currency changes are measured in cents or ‘pips’. And indices are measured in ‘points’. Hence the “FTSE rose thirty points” yesterday.

When Is An Average Not An Average

So far I’ve made the maths of indices sound quite simple – and indeed it is. However every index uses its own flavour of ‘simple’. For example the Dow uses a “price weighed” average. So the value of the Dow is based on adding up the price of each of its constituent stocks and dividing by the number of stocks in the index.  The effect of this is that the index becomes biased towards the stocks with the highest share prices – so a $1 rise in General Electric may be countered by a $1 fall in Du Pont, despite the fact that General Electric is almost 10 times larger than Du Pont.

The large majority of indices, including the FTSE, the ISEQ, the S&P 500 and the Nasdaq 100, get around this problem by using a ‘market cap weighted average’ calculation. Now I can explain that in two ways – using maths or not using maths.

Here’s the non maths explanation: ‘market cap weighted average’ indices are set up so that the change in the price of a company with large market cap (e.g. Vodafone) will have a greater impact than that of a smaller company (e.g. Thomas Cook). Which kinda makes sense – after all more people have invested more money in Vodafone than in Thomas Cook (hence Vodafone having the larger market cap. So Vodafone can be thought of as a more important player.

For the good-with-figures types (and you’ll notice I’ve avoided the obvious sexual innuendo jokes here) the way it works is you add up the market cap for every stock in the index. That gives you the ‘index market cap’. Then divide each constituent company’s market cap by the index market cap and you get the weighting for those companies.

So let’s say Vodafone has a market cap of £100bn and the FTSE has a market cap of £1,500 bn. In that case Vodafone has a weighting of 100/1500 * 100 = 6.6% of the FTSE. And if you are wondering why you should care about this … read on!

Lesson 1 – Know What’s In Your Basket

When trading an index it’s always worth knowing what that index consists of. Now in practical terms it is hard to keep track of all 100 stocks in the index – however you should keep your eye on:

a) the largest stocks with the largest weighting and
b) the sectors that are most heavily represented.

The ISEQ, for example, fell 19% in 2007 and was one of the poorest performing indices in the world – only Venezuela did worse. Run a finger (an index finger … geddit?) down the list of constituents and you’ll soon see why. The top 5 Irish companies are CRH – a cement manufacturer – and four retail banks. You couldn’t have got a better exposure to a falling housing market and credit crunch issues if you tried.

Lesson 2 – Watch The Reshuffles

Most indices have a fairly strict set of rules that decide which stocks should – and should not – be constituents. The publishers of the index hold reviews every so often and if a company no longer matches the criteria it is replaced.

The FTSE 100, for example, only holds the 100 or so largest companies listed on the London Stock Exchange, with market cap being used as a proxy for size. So if a share price collapses, as was the case with Northern Rock, then the market cap declines and the share needs to be replaced with a larger one.

The FTSE 100 and 350 indices are reviewed and changed every quarter, in March, June, September and December. As many fund managers track the FTSE 100 they will need to buy the new shares entering that index. But money doesn’t grow on trees so to generate the cash to buy those shares they’ll have to sell something. And guess what’ll be top of the list to be sold? Yep … the shares that are no longer part of the index.

Summarising all that into one sentence: a stock exiting the FTSE is going to drop in price and a stock entering it is going to rise. In the short term at least.

Unlike the FTSE, which has a strict set of mathematical criteria for inclusion, the Dow and the S&P 500 are reviewed by committees and changed whenever the respective committee feels it is necessary. Changes to the Dow, in particular, are few and far between…

Imagine having a short position on the Dow Jones, which is constituted of 30 of the largest companies trading in the USA, and 12 of them pay their dividend on a particular day. 40% just paid a dividend when you had a short position in place which means the dividends will show up as a debit on your account. The Dow might have fallen on this day and you might have mistakenly thought that you would be ahead, but instead the dividends wiped out your profit.

Lesson 3 – Dividends Count For Spread Bets Too

Let me say two things at the start of this section. Firstly this bit is really about accounting – in reality it’s going to make little or no difference to your wealth. So if you want to skip on to Lesson 4 be my guest. However if you are the ‘nuts-and-bolts’ type read on … Secondly this bit is going to make absolutely no sense unless you’ve know how spread betting companies handle dividends. So take a few minutes to remind yourself with the relevant bits of the What Is A Dividend post.

Right, now that’s done you’ll remember that you either receive or have to pay dividends for rolling daily bets share prices if you have a position open. Well an index is just a basket of stocks. So if a FTSE 100 stock, for example, is paying a dividend and you have a long position on the FTSE Rolling Daily you’ll see a small payment into your account. Equally if you have a short position again you’ll see a small payment leave your account.

The size of the payment is determined by the weighting of the stock in the index. So you’ll see a bigger figure from a Vodafone dividend than a Thomas Cook one. Both are pretty small though.

Firstly don’t forget the 90% long, 100% short thing I talked about post holds true for indices too. So if you have a long index position you’ll be receiving 90% the dividend and if you have a short position you’ll have 100% of the payment deducted from your account.

Also although there will be a cash adjustment in your account, in reality it makes no difference to your wealth. This is because, just like a share price falls when it pays a dividend, so an index price also falls when the stocks it contains goes ex-div.

So what you end up with on an ex-div date is:

• If you are long you receive a dividend – but you lose a bit as the price of the index falls.
• If you are short you paid a dividend – but you gain a bit as the price of the index falls.

As I said at the beginning, the end result is little or no difference to your wealth. And if you aren’t the nuts-and-bolts type I bet you wish you’d taken my advice and skipped this section!

Lesson 4 – Don’t Forget That An Index Is Just Stocks

The final point in this list is so simple it might sound dumb – and yet it is such a common mistake. Time and again people forget that the FTSE and the Dow are not instruments in themselves. So when the index rises or falls people look for macro-economic reasons like sovereign debt troubles and the USA’s fiscal cliff rather than looking at the news flow for particular companies or sectors.

A useful tool to understand a bit more about what is moving a market is a heat map. It shows which sectors that are having the most impact on an index price. Digital Look have a free one, although you have to register. Also take note: it shows movement across all stocks, not just those in a particular index.

Having said that with indices there is less need for scrupulous analysis of individual companies balance sheets and cash flows and as such technical analysis is even more important here. Indices are also less volatile than individual shares where moves of 2% or more are quite common. Since indices are a basket of stocks, their very nature means that big rises in particular constituents tend to be offset by market laggards. This makes indices less predictable in turbulent markets. While individual stocks could move up or down 10% or even 20% during very volatile trading sessions, an index might only move 4% and as such indices attract more activity during volatile times.

At the time of writing [March 2013] we are seeing the Dow Jones setting new all-time highs, as has the UK’s FTSE 250 index. The fiscal cliff hasn’t stopped share prices from pushing higher either. These rallies can be partly attributed to an improving economic picture but mostly the support is coming from central banks. The Federal Reserve for one is continuing to buy $85bn of Treasuries and mortgage-backed securities each month and this is acting as a catalyst driving force for the markets.

What affects Indices?

Indices are affected predominately by the performance of the stocks listed on them, so in a sense, the internal and external factors that affect share prices will affect the wider markets. However, since an index is representative of a certain group of shares, either in a particular country or a particular sector, its movement can be influenced by what’s happening in that country or sector.

If, for example, the technology industry is booming while the financial sector is struggling, then indices that are more heavily weighted in technology stocks may perform better. Similarly, if there are economic problems in the US, then indices in the country may fall further than those in other countries where the economic situation is better.

Of course there is no exact science, and indices can also be affected by rumour, hype, speculation and investor confidence, as well as global events such as terrorist attacks, political instability and conflict. It is therefore essential when spread betting on indices to keep a close eye on current affairs and economic news, as almost anything could have an impact on your chosen market.

There is no direct commission on trading index spread bets with providers simply adding a little extra on the market spread. For instance popular markets like the FTSE 100 or the Dow Jones 30 might only cost you point or two, although the other markets can be more expensive. Index markets are priced using the respective futures contracts and are generally very liquid, particularly while the underlying stock exchanges are trading. You can either bet on a futures based index, in exactly the same way and over the same periods as a share, or you can place a daily bet. This type of bet dies at the close of business in the market to which it refers. The daily FTSE 100 will open at 0830 hours in London and close at 1630 hours. The daily Dow Jones opens and closes with Wall Street. However, it is also worth pointing out that one can deal in most major indices after-hours with the Dow Jones Industrial Index, S&P 500, Nasdaq 100 and Russell 2000 small-cap benchmark indices available to trade round-the-clock from Monday to Friday via a spread bet.

The amount by which an index moves in a day is generally not great, although in recent times we have experienced a few trading days when falls of 200 points have been registered – however it is more usual for big movements to follow after a catastrophe or some extraordinary bad news such as a major bank failure, or substantial and very expensive disaster. Since the spread betting company will quote spreads of around 2 to 8 points on indices, you need to see a minimum movement in the ‘price’ of 2 to 8 points (respectively, depending on the index market) before you break even.

Most Popular Indices: FTSE vs Dax vs Dow by David White of Spreadex

And To Summarise…

Im sure features are meant to be short, sharp and to the point. But not mine – oh no – mine are beasts. And Ive covered so much stuff here that I’m going to end with a summary.

• Indices are a ‘basket of stocks’. They rise or fall depending on what happens to their constituent stocks.
• Most indices use a ‘market cap weighted average’ calculation, so they are more heavily affected by large stocks than by small ones. However a few, including the Dow Jones 30, don’t use this method.
• It pays to know what stocks and/or sectors are heavily represented in your index.
• If you trade rolling daily indices you’ll see some dividend adjustment payments either entering or leaving your account. However these will probably make little or no difference to your wealth as they’ll be offset by changes to the index price.
• If you are trying to understand why an index is moving up or down have a look at which of the underlying stocks / sectors are moving the most.

If you now feel that you want to get stuck into trading, you can always open an InterTrader Demo Account. If you feel that you’re ready for the real thing, they can open a Live Account for you.

That’s it for now. May the markets be with you.

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