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Synthetic indices are designed to simulate market-like volatility, but they are not tied to actual assets such as stock, bonds or commodities. This also means they are not impacted by real-world events such as black swan events, although price volatility and unpredictability still exist.
But while they are not linked to any real assets, synthetic indices nonetheless can exhibit a similar degree of volatility and unpredictability as real-world markets. Through unique, algorithmic-driven mechanics, synthetic indices offer simulated price movements that share similar characteristics as live securities, allowing traders to trade them as they would real assets.
In this article, we will take a peek under the hood at how synthetic indices work, and what drives their movement.
Key Points
- Synthetic indices are driven by algorithms that simulate real-market volatility using programmable rules.
- Their price movements are generated by random number systems, not by real-world news or economic events.
- Traders can access predefined volatility profiles and round-the-clock trading, without disruptions from global events.
What Moves Synthetic Indices: Decoding the Price Action
Synthetic indices are driven by proprietary mathematical and probabilistic models. In this section we’ll look at how these mechanisms work.
The Concept of Algorithmic Pricing
In simple terms, an algorithm is a set of rules that are applicable to solving a problem or completing a task. Algorithms are used widely in finance, becoming an important part of automated and high-frequency trading (HFT) systems, as well as in determining the pricing of derivatives and other sophisticated instruments.
In the context of synthetic trading, algorithms, too, are present. Specifically, they are deployed in algorithmic pricing, which is the mechanism that drives the price movements of synthetic indices.
With algorithmic pricing, price movements are not arbitrary. Instead they are pre-programmed based on specific mathematical models.
To maintain volatility and unpredictability, algorithmic pricing makes use of pseudo-random number generators (PRNGs) which are specifically designed to accomplish several objectives. One such objective is to simulate price behavior with a defined level of volatility (this level of volatility can be altered by making changes to the algorithm).
Algorithmic pricing aims to be statistically consistent over time. Some brokers also provide tools that support transparency, such as auditable or verifiable randomness.
In fact, some brokers make it a point to make their algorithmic pricing models auditable – such as with cryptographically verifiable randomness. This further increases trust among synthetic indices traders.
Simulating market-like volatility
Synthetic indices are programmed to simulate varying levels of market volatility by changing relevant aspects of the algorithm that drives them. Here’s a breakdown of this works:
Essentially, synthetic indices are programmed using mathematical models that embed varying levels of market-like volatility into their behavior. Each index is assigned a volatility coefficient that determines the average amplitude and frequency of price fluctuations per tick.
These coefficients control how much the price moves in response to each random number generated by a pseudo-random number generator (PRNG). A low-volatility index will produce smaller, smoother price movements, while a high-volatility index exhibits sharper, more frequent swings; the latter may resemble volatility seen in more turbulent markets such as crypto or emerging market forex pairs.
The volatility programming isn’t just about size of movement, but also the behavioral profile of each index. Some are modeled to trend with retracements, while others are programmed to oscillate or spike unpredictably. The underlying engine often factors in mean reversion tendencies, momentum bias, and burst probability, depending on the index type.
This structured behavior may allow traders to apply technical strategies similarly to real markets, with volatility levels defined by the algorithmic model.
Product types
Vantage offers the following product types for those interested in trading synthetic indices via CFDs:
- FixedVol: Features steady price fluctuations with a consistent movement range, useful for applying systematic strategies.
- SpikeUp/SpikeDown: Simulates sudden market shifts, mimicking breakout behaviour.
- FixedStep: Designed to replicate trending markets with measured price steps.
Ensuring fairness and integrity
Since synthetic indices are driven by algorithmic pricing that are proprietary owned by brokerages, naturally questions may arise as to whether the game may be rigged, so to speak.
As mentioned earlier, algorithmic pricing follows predefined rules, and in some cases may be designed to promote transparency and consistency. Furthermore, reputable CFD brokers like Vantage implements verifiable random number generation and clear rules for price generation, further increasing trustworthiness and integrity.
What doesn’t move synthetic indices?
Unlike traditional indices, synthetic indices are unaffected by real-world market drivers. This makes them more predictable in terms of what factors influence their price movements.
Fundamental economic data
Real-world markets are impacted by fundamental economic data, the tone of which can shape or alter price trends to varying degrees. For instance, stock indices are often affected by earnings reports, creating short-term volatility when earnings are released. Other examples include bond indices, which may go up when inflation is high.
Synthetic indices are not linked to any real-world markets. As such they are not affected by fundamental economic data trends or reports. Traders can carry on trading without making provision for earnings seasons.
Company-specific news
Stock prices can plunge on sudden news of a company scandal, causing price gaps that can exceed your stop losses.
However, synthetic indices are not based on any real-world companies, and thus immune to the effects of any company-specific news.
Geopolitical events
Wars, elections, regime change, trade tariffs and oil production adjustments are just some of the numerous geopolitical events that regularly rock the market, adding noise and uncertainty.
Synthetic indices, however, do not have any real-world linkage. That means geopolitical events do not show up on the price chart, and can be safely ignored by synthetic index traders.
Supply and demand mechanics
Commodities such as oil, coffee, steel and agricultural produce are driven by supply and demand, which varies according to weather occurrences and other events that can be difficult to predict. This introduces a layer of volatility that can catch commodity index traders off guard.
Synthetic indices are not impacted by supply and demand levels, providing clearer price action that is purely driven by the algorithm.
Real-world market holidays or closures
Stock markets observe business hours, and do not trade round the clock. They also close during major holidays.
With synthetic indices, there are no closures during holidays, nor is trading restricted to business hours. Traders can carry on trading 24/7.
The Advantages of Algorithmic Pricing for Traders
Algorithmic pricing offers many benefits for traders over traditional live market trading. Let’s explore some of these in detail.
24/7 trading opportunities
One of the most apparent advantages of algorithmic pricing is the ability to trade 24/7. This is because there is no linkage to real-world markets; hence there’s no need to observe holiday closures or market hours.
Predictable volatility profiles
As explained, synthetic indices come in various programmes catered to different trading styles. There are also various volatility profiles to choose from. Thus, traders can pick a synthetic index to trade that suits their preferences in terms of strategies and time horizon.
Importantly, a synthetic index series comes with varying volatility profiles, ranging from low to high. Traders can choose a volatility profile they are comfortable with, as the volatility levels are predefined within each algorithmic pricing model, offering consistency in price behavior over time.
Focus on technical analysis
Because of their algorithmic, pattern-generating nature, synthetic indices are highly suited to technical analysis. Traders may find their technical indicators producing more accurate and reliable outlooks; this is also a great way for traders to hone a finer understanding of technical analysis in the context of purer price action.
Independent of global events
As mentioned earlier, synthetic indices are not based on any real world markets. Thus, they are not impacted by global events, such as recessions, geopolitical instability, company earnings reports, policy changes, trade tariffs and the like.
This means that synthetic traders can focus on algorithmic-driven trading without reacting to external events—though price movements remain volatile and can still be unpredictable.
Conclusion
In this article, you have learned that synthetic indices are driven by sophisticated algorithms and random number generators, creating simulated yet dynamic price movements based on pre-defined models. This setup allows synthetic indices to offer volatility simulating real-world markets, but without the uncertainty of destabilising real-world events.
Importantly, the price movements of synthetic indices are not arbitrary, rather they are the direct result of pre-defined algorithmic rules. Algorithmic pricing models are also auditable and verifiable, providing transparency and trust.
Traders who want to trade pure price action free from real-world factors might find synthetic indices to be an exciting addition to their range of trading options. Furthermore, traders can choose from a range of different indices and volatility profiles to better fit their needs and objectives.
Trade Synthetic Indices via CFDs at Vantage
You can explore synthetic indices via CFDs on Vantage. Open a live account, or practise with a demo to get a feel for how these instruments behave.
Vantage offers tools to chart synthetic indices, execute orders quickly, and manage risk with clarity. With round-the-clock access and a range of synthetic index types, Vantage offers tools that allow traders to explore and test different strategies in a simulated market environment. However, note that these instruments still carry risk and may not be suitable for everyone.
Frequently Asked Questions
Are synthetic indices manipulated?
No, synthetic indices are not manually manipulated. They follow algorithmic pricing models that use pseudo-random number generators and volatility coefficients to simulate market-like price movements. These models are designed and maintained by the broker.
Some brokers provide additional transparency by using verifiable random number generation or making algorithm parameters auditable. However, pricing mechanisms and rules may vary depending on the provider.
Are synthetic indices connected to real-world events?
Synthetic indices are not based on any real markets or companies, and are designed to operate independently of real-world events. Their price action is generated by algorithmic pricing models, using pseudo-random number generation and volatility parameters rather than external market data.
