Market maker CFD provider create synthetic indices over various index sectors including banking, insurance, gold and transport. This provides traders and investors with the opportunity to trade these market sectors rather than trying to find individual shares within a sector. For example, a trade may have a particular view on the transport industry as a whole. Rather than trying to determine which individual share CFDs to trade from within that sector, a position could be taken over the transport sector index. The most direct benefit of this is diversification of risk as your exposure is split across multiple companies the sector.
In the United Kingdom, Sector Indices are based on the FTSE 350 which cover over 90% of the All-Share index by market capitalisation. The classification system was changed in the past so that today the sector groupings are made of some 18 highly tradable real-time sector indices as well as a number of sub-sectors. These cover most of the main industries including banks, fuel, technology and retail. A Sector CFD makes it possible to trade those indices and take advantage of key macro economic trends in the market. One thing you should be aware, however is that certain Sectors offer more diversified exposure than some of the others; for instance just to name one the ‘Automobiles and Parts’ is only made of one or two companies while ‘Retail and Support Services’ each have more than 20 companies.
Sector CFDs make it possible to capitalize directly on key macro-economic trends in the market. Sector indices tend to produce smoother trends with less intraday volatility than individual shares, as they represent a broad basket of stocks from within that particular sector. This makes it easier to use trailing stop losses as there is less likelihood of a position being prematurely stopped out and allows traders to take longer-term views than with certain other instruments as it is easier to manage the position.
A disadvantage of Sector CFDs is that they tend to have wider spreads as they are not very liquid so in some cases it might actually be cheaper to trade the underlying company. This applies especially to cases where one or two companies dominate the sector; for instance in the telecoms exposure, it would probably be cheaper to trade BT than the sector since the company’s dominance of the sector means the two are very much correlated. Another problem with Sector CFDs is that since they are constituted of many different companies; it is more difficult to do any fundamental research on them. Of course, the good thing is that a Sector CFD takes stock-picking out of the equation…
The picture below highlights the much smoother trend, with less volatility, of the consumer staples sector as a whole, as opposed to the erratic chart of CCL – a key component in this sector. It is however important to note that while sector trading does remove the need for individual stock selection decisions, some of the indices or sectors can be dominated by one or two stocks, weighting the sector heavily in line with those few stocks.
A useful quality of CFDs is that they allow traders to ‘buy’ or to ‘sell’ an instrument which provides the opportunity of using sector contracts in slightly more sophisticated combination trades. This strategy involves going long on one sector and short on another (or a sector versus a market). For instance taking a cross long trade on banking and a short on general retailers will stand to generate a gain as long as the banking sector outperforms the retail sector. If you match the monetary exposures, the combined positions won’t be affected by external factors that affect both sectors in a general way. Thus, one can consider this as a kind of hedge with the cost consisting of the double spreads but it should in no way be considered risk-free and in the worst case scenario both positions would incur a loss.
Such trades would be more suited in situations where the macro-economic landscape changes like a change in interest rate. An increase of interest rates would impact negatively the cyclical sectors and one could potentially short the techs and go long in a defensive area like drugs.