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Index Trading Comparison: CFD, ETF or Index Future

By Lawrence  

Alphabet BlocksAnyone interested in trading the stock market indices have to choose among many alternatives available nowadays. Finding out the specific financial instrument that is best to trade with can be difficult. After all, who would have imagine that index trading has become such a big hit among the trading instruments. Currently, there are three most common choices to choose from – CFD (contract for difference), ETF and index future. They all have their strength and weaknesses. I will explain in this article what they are good for in different situations.

Index Future Is Best Overall For Its Liquidity

One of the most important characteristics that a market need for better trading experience is good liquidity at the bid and ask level. This is known as having a tight spread. With tight spread, you can enter a trade at market price and exit right after with just one tick loss, the smallest increment of the price.

The most common index future contract in North America is the emini S&P. During normal trading hours, you can consistently find several hundred contracts at both the bid and the ask price where they are just one tick apart. This makes it easy for small traders to enter and exit the market without serious slippage issues most of the time.

Slippage is the daunting issue of not being able to get fill at a reasonable price with a market order. The moment you try to enter an order at market, your order could be one of many other orders trying to do the same. In a market with liquidity issue, there will not be enough pending orders in the price book to absorb all the orders. Hence you may get a price worse than what you think you are suppose to get.

Many index future markets are very liquid, making it possible to enter and exit the market with predictable precision (i.e. limited slippage). Due to the limitation with day trading, a trader may not have enough time to wait for a fill for the orders. Thus it is important to be able to get in and out of the market quickly whenever it is needed.

Good liquidity makes index futures best among the three classes of index markets for day trading and trading in general.

Index CFD Is Best For Small Traders Learning To Swing Trade

CFD is short form of Contract For Difference. It is a special kind of market. CFD is not a standardized instrument listed on exchanges. It is essentially a betting instrument provided by a firm for you speculate in the particular market you are interested in. There are stock CFDs, commodity CFDs and other types of CFDs. CFD is very popular in UK because it is considered as a kind of betting as oppose to trading in regulated trading instruments like stocks. So technically it is tax free to speculate in CFDs in some parts of the world.

Lately, CFD is introduced to North America by several big CFD / Forex firms. Regulators in North America have been very picky about the way CFDs can be offered thus the availability is very limited and not everyone can open an account with these firms to trade CFDs. One of the original selling point of trading CFDs is the ability to use  very high leverage. Due to the restrictive regulations, the CFDs offered in Canada and United States require higher margin, making them not as attractive as the offerings by the same firms in Europe.

The advantage of CFDs is the ability to trade in micro lot size. Hence you can be a speculator without risking the kind of money that index futures would require. Most of the bigger CFD firms offer their own order placement software with real-time quotes tracking the actual underlying index or index future pretty closely, so trading the CFDs is not that much different from trading the real thing.

The disadvantage with CFDs is that these firms offering the CFDs have to make money off the spread of the price. Spread is the difference between the best bid and ask price at any moment. From my experience, there are firms whose spread is about 0.5 point of the S&P and there are firms offering spread at as low as 0.15 point. The difference is huge and would add up quickly if you are going to move size with them.

Another issue with trading CFDs is the firm you are going to trade with can be the source of problem. Remember that CFD is offered by the firm for you to bet on. The firm offering you the service is essentially betting against you, unless it is big enough with many clients so that the risk is properly distributed among the clients. The firm can also offset its risk by proper hedging against the bets placed by the clients automatically. A CFD firm that hardly making any money may choose to scam money from its clients through rigged bid/ask pricing. Hence the size and reputation of a CFD firm is very important when you are considering to open an account with one.

As a whole, the weaknesses in CFDs making it not the best choice for day traders. On the other hand, if you are trading very small size to learn to swing trade the indices, it is a very reasonable vehicle to work with. For example, the regular margin requirement for trading 1 emini S&P contract would allow a trader to trade 50 units of S&P CFD. That will allow very efficient scaling in and out of a position similar to a sizable hedge fund.

CFD is a great choice for anyone whose interest is swing trading the indices and that the position size is not going beyond the equivalent of say 10 contracts in emini S&P.

Index ETF Is Needed For Special Account Requirements

For those whose investment / trading capital being locked in special accounts like the Canadian’s RRSP and United States’ IRA, they may not be able to trade index futures nor the index CFDs. That pretty much leaving just the ETFs as the only choices to trade the indices.

There is no special advantage to trade the ETFs (e.g. SPY). A standard lot is 100 shares. Going below the regular lot size your trade may have to be routed to odd-lot dealers as oppose to directly handled through the regular channels. If you have very small size trading account, trading ETFs is not as flexible as trading CFDs.

Day trading ETFs subjects the trader to the pattern day trader rule (PDT) which enforces a minimum account size for those involve in entering and exiting their holdings within a day or two. That raised the barrier to entrance for the small investors to proper investing. As they cannot learn to trade properly before raising enough money to cover the PDT minimum account size, it would in turn making sure that they would more likely losing money instead of making it in the stock market due to lack of trading experience.

If a trader has enough trading capital and experience, trading ETFs is not necessarily a bad thing. The advantage includes capital gain tax rate, special dividend treatment and reasonable liquidity. For certain parts of the world including Canada and United States, stock brokerage accounts are insured up to certain limit so it has the advantage of extra protection from brokerage firms.

The main advantage with ETFs like SPY is the potential of cheap commission. Some brokerages offer very low commission rate to ETFs traders that is comparable to, and often better than, the index futures commission rate. The catch is that trading ETFs requires more margin in general so those traders who are not trading with special brokerage accounts would be under utilizing their trading capital significantly.

In short, ETF works very well for those who are not looking for high leverage, have capital well beyond the PDT rules (or if that does not apply to your country) and the trading experience to utilize them.

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