Synthetic indices are a relatively new class of trading instruments that can provide asymmetrical market risk for investors and traders. There is plenty of public misconception about how they work and in this post, we hope to clarify how they work and why you should consider them. Synthetic indices are complex financial instruments and as such it’s important to fully understand their risk before you decide to trad them.
- Synthetic indices are artificial financial instruments available for trading based on a number generator that is secured through cryptography
- The main company that provides trading access for these artificial indices is Deriv
- You can trade these instruments 24/7 as the market is always open for them
- There are 6 different types of synthetic indices available for trading: volatility, crash & boom, continuous, step, range break, and jump indices
- They are considered highly volatile and leveraged and should be treated with extreme caution
What Are Synthetic Indices?
Synthetic indices are artificial financial instruments that were created to mimic real-world market movements in different markets based on a random number generator that is secured through cryptography.
This mechanism is used to prevent market manipulation and improve financial transparency. The broker that provides trading for these instruments can’t manipulate the price or predict which numbers will be generated to maintain trading.
They are just like other trading instruments, but they have constant volatility and trade 24 hours a day 7 days a week. News events or natural disasters don’t have an impact on their pricing. The price of these indices is generated randomly by a highly specialized computer program and is audited by a third-party program. This makes synthetic indices completely speculative and extremely risky in nature due to their unpredictable price behavior.
Important Things to Know About Synthetic Indices
As previously mentioned, the prices of synthetic indices are generated randomly by a highly sophisticated computer program that gets audited by a third-party program to uphold fairness and transparency. They are not real financial instruments, they are stimulated to reflect real market instruments. The main trading broker who sponsors access for synthetic indices is Deriv. It’s important to note the following properties of synthetic indices:
- The price can’t be manipulated by a single individual or large block trades
- Deriv does not have access to the price before it is generated
- The price that will be generated is not known as it is randomly generated by the computer system
These properties make synthetic indices products extremely risky and speculative, therefore they should be treated with extreme caution.
Why Trade Synthetic Indices?
Synthetic indices offer a highly leveraged trading environment along with tight spreads for traders. If you want to trade an instrument that is highly volatile and provides trading 24/7, synthetic indices are an option. It’s important to note that trading synthetic indices don’t require a ton of capital. You can start trading them with less than $1,000.
Although they are unpredictable instruments, traders are aware of the risks of trading synthetic indices from the start. There is also a good amount of indices available for trading that can provide different levels of risk and exposure for traders.
Different Types of Synthetic Indices Available for Trading
Synthetic indices have 6 major categories available for trading. They include:
- Volatility Indices
- Crash & Boom Indices
- Continuous Indices
- The Step Index
- Range Break Indices
- Jump Indices
The volatility indices are artificial indices that reflect real-world markets with non-stop volatility. These indices have constant volatility with given percentages with each tick that is generated. For example, the volatility 75 index has constant volatilities of 75% with one tick generated every second.
The fixed volatility component is advantageous to traders because they know the volatility amount before it even happens. Below are the most popular volatility indices available for trading.
|Volatility 10 (1s)||An index with constant volatilities of 10% with One tick is generated every second|
|Volatility 25 (1s)||An index with constant volatilities of 25% with One tick is generated every second|
|Volatility 50 (1s)||An index with constant volatilities of 50% with One tick is generated every second|
|Volatility 75 (1s)||An index with constant volatilities of 75% with One tick is generated every second|
|Volatility 100 (1s)||An index with constant volatilities of 100% with One tick is generated every second|
|Volatility 10||An index with constant volatilities of 10% with One tick is generated every two second|
|Volatility 25||An index with constant volatilities of 25% with One tick is generated every two second|
|Volatility 50||An index with constant volatilities of 50% with One tick is generated every two second|
|Volatility 75||An index with constant volatilities of 75% with One tick is generated every two second|
|Volatility 100||An index with constant volatilities of 100% with One tick is generated every two second|
Crash & Boom Indices
Crash and boom indices are meant to reflect fluctuating real-world monetary markets. They behave very similarly to normal financial markets and have different price behavior compared to volatility indices.
For example, the Boom 500 Index has on average 1 spike in its price series every 500 price ticks. On the other hand, the Crash 500 Index has on average 1 drop in the price series every 500 ticks. This price behavior helps traders quantify and more accurately predict price booms and crashes. Below are the most popular crash and boom indices available for trading.
|Crash 1000||On average 1 drop occurs in the price series every 1000 ticks|
|Crash 500||On average 1 drop occurs in the price series every 500 ticks|
|Boom 1000||On average 1 spike occurs in the price series every 1000 ticks|
|Boom 500||On average 1 spike occurs in the price series every 500 ticks|
As the name implies, continuous indices never stop trading. They trade 24/7/365. An advantage to the continuous index is that you can trade on the weekends when the regular market isn’t open. The majority of synthetic indices are continuous.
The step-index mimics the real market step by step. It has an equal probability of going up and down and has a fixed step size of .10. Advantages to using the step-index is knowing the exact probability of the market going up and down which allows you to manage your risk accordingly.
Range Break Indices
Range break indices simulate a ranging market that breaks out of a trading range after a certain amount of attempts. The two most popular range break indices are the Range 100 index and Range 200 index.
The Range 100 index breaks out after an average of 100 attempts while the Range 200 index breaks out after an average of 200 attempts.
Below are the most popular range break indices available for trading.
|Range Break 100||Index that breaks the range once every 100 attempts on average|
|Range Break 200||Index that breaks the range once every 200 attempts on average|
The jump indices measure the price jumps of an index with an assigned uniform volatility percentage per hour. For example, the Jump 10 Index has an average of 3 jumps per hour with uniform volatility of 10%.
Let’s take a look at some of the most popular step indices available for trading.
|Jump 10||An index with 10% volatility and 3 jumps per hour on average|
|Jump 25||An index with 25% volatility and 3 jumps per hour on average|
|Jump 50||An index with 50% volatility and 3 jumps per hour on average|
|Jump 75||An index with 75% volatility and 3 jumps per hour on average|
|Jump 100||An index with 100% volatility and 3 jumps per hour on average|
What are the Most Popular Synthetic Indices to Trade?
The Volatility 75 Index is the most popular synthetic index to trade. The reason it’s the most popular choice for traders is that it’s the easiest to make money with using a small trade size.
This index has a 75% volatility and 3 jumps per hour on average. This provides traders with plenty of volatility to make money with a small amount of cash.
Advantages of Trading Synthetic Indices
There are some important advantages to trading synthetic indices over other financial derivatives.
- They have uniform volatility. This provides a fixed level of risk for traders as they know what kind of volatility behavior the index they are trading will have.
- You can trade them 24/7/365. Unlike stocks, forex, options, or futures which are available for trading only at certain times of the working week, synthetic indices can be traded anytime.
- Different instrument options. There are different synthetic markets that you can trade that behave differently and offer different risk characteristics and parameters.
- Fundamental factors don’t impact the price of synthetic indices. Interest rate announcements and inflation data don’t directly impact the price of the instruments.
Disadvantages of Trading Synthetic Indices
Although synthetic indices have their advantages, they also come with their own set of disadvantages as well.
- They can be extremely volatile. Although this is quite obvious it’s important to understand just how volatile these products can be. If you don’t understand position sizing and the type of synthetic index you are trading, you can quickly lose all your capital.
- Limited brokers offer them for trading. There are very few brokers that offer synthetic indices for trading with the most popular broker (Deriv) operating out of the EU.
- Can pose overtrading risk. Since they are available for trading 24/7, traders can become very prone to overtrading if they don’t have proper discipline and risk management practices in place.
If you decide to trade synthetic indices, we highly advise that you first trade them on a demo account before going live. Give yourself some time to learn their volatility in a demo environment before you decide to trade them in a live environment.