What is Index Trading and How Does it Work?
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Indices available on today's financial markets are extensive and varied. In the currency market, indexes (both indices and indexes are the plural of index) are accessible on the majority of major currencies, such as the U.S. dollar—for example, the US Dollar Index is a geometrically weighted index of the dollar’s value against six international currencies. Additionally, there are indices based on the performance (the price change) of equities or shares in a specific country, traded on a public exchange. For instance, the FTSE 100 is an index that monitors the performance of the 100 largest companies listed on the London Stock Exchange (LSE). Trading major stock indices like the FTSE, therefore, allow traders and investors to gain exposure to an entire economy through a single trade (investment). There are also indices designed to track the performance of certain sectors and industries in a country.
Other well-known stock indices include the S&P 500 out of the U.S., Japan’s Nikkei 225, and the MSCI World Index, which works with 23 large and mid-cap equities in developed markets. With the help of a Contract for Difference (CFD), a derivative contract designed to allow traders and investors to trade on the price movement of underlying assets, such as stocks, currencies, and bonds, for example, they are able to speculate on rising and falling prices. This is often referred to as "going long" (buy) or "going short” (sell), without taking ownership of the underlying asset.
Index Trading Defined
Index trading is defined as the buying and selling through a market index. This could be based on a stock market, the commodities market or even currencies. Index traders are, therefore, free to concentrate their efforts on a single index or trade multiple indices as part of a more comprehensive strategy.
Since indices are merely indications of changes (mathematical calculations) in the prices of several assets and do not have a physical basis on which they can be delivered (how could an index be delivered?), it is not possible to buy or sell an index directly in the same way that one would an individual stock or a commodity. To trade indices, market participants will employ derivatives, such as index futures, CFDs, digital 100s, and Exchange-Traded Funds (ETFs).
A derivative’s exchange is a platform designed for trading in indexes, amongst other derivatives. The world's largest financial derivatives exchange, the Chicago Mercantile Exchange (CME) Group, was formerly recognized as the Intercontinental Exchange, the latter of which is the New York Stock Exchange (NYSE) owner.
Reasons Why Index Trading Is Good for You
- Health of a Country’s Market
A stock market index, for example, provides a clear snapshot of a market’s health in a country, sector, or industry, helping to gauge risk sentiment. Indices also permit market participants to hedge an underlying asset.
- Long and Short Trading Positions
The ability to trade long and short an index is a plus for many investors.
Since indices often work with high liquidity, traders benefit from narrow spreads and clearer (or cleaner) price action. This can help recognize technical chart patterns, such as Head and Shoulder Patterns, Double Top and Double Bottom Patterns, Triple Top and Triple Bottom Patterns, Wedge Patterns, Pennant or Flag Patterns, and more.
Different Ways to Trade Indices
- Index Futures:
Index futures are legally binding cash-settled agreements to buy or sell a financial instrument at a predetermined price at a future date. However, do be aware that you can buy or sell futures before the expiry date. Some popular futures contracts are based on: crude oil, corn, natural gas, soybeans, gold, and, of course, market indexes.
The Commodity Futures Trading Commission is in charge of policing futures markets (CFTC), the global standard for futures market regulation.
Important Terms to Understand in the Futures Market:
You can trade futures contracts on a wide variety of assets, such as ETFs, oil, stocks, cryptocurrency, and market indices, as well as other financial instruments.
A futures contract will have an expiry date; this is when the contract ends. It is considered standard procedure for investors to have already decided what they will do with their position that is about to expire.
Using leverage, investors only invest a small amount of initial capital. Importantly, leverage can increase profits though equally increase losses in the event of unfavorable trade. It is prudent to educate yourself concerning leverage before investing.
Futures fees are determined by individual contracts; some fees are as follows: Exchange/clearing fees, National Futures Association (NFA) fees, data fees, and brokerage commissions. It is the trader's responsibility to understand the cost involved. Your broker should be transparent about their fee structure.
- Cash Indices:
Cash indices are traded at the spot price (current market price available). It is the current aggregated performance of a specific index.
The spot Forex market is one of the most common spot markets, commonly traded using T + 2 settlement (settled within 2 business days). Forex is the busiest market worldwide, trading over US $7 trillion per day. Stocks and bonds are normally settled using The T+3 method (settled within three working days). For options and government securities, T+1 (the next business day) is most commonly used as the settlement date. Every marketplace endeavors to achieve settlement times of T+1 or even the same day whenever possible. The risk of default by the counterparty can be reduced with the use of a shorter settlement term.
CFDs are a popular way to trade cash indices on both the spot and futures markets, usually with more favorable leverage. Some popular stock index CFDs are the DJI30 (Dow Jones Industrial Average), the Dax40 (German stock market), and the ASX 200 (Australian stock market).
- Index Options:
The holder of an index option, a type of financial derivative, has the right, but not the obligation, to buy or sell the value of an underlying index at the strike price on indexes, such as the Nasdaq 100.
Index Trading Strategies
Traders employ trend trading strategies to execute trades during an early trend or in the midst of a trend. When the index is trading in a specific direction, traders anticipate that it will continue moving in the same direction over the long run and make judgments regarding whether or not to engage in long (buy) or short (sell) trades based on this assumption.
Support and resistance can also play an essential role in trend trading; therefore, it is crucial to understand support and resistance concepts.
The Bollinger Bands indicator is a technical analysis tool traders use to measure volatility. The bands are also frequently utilized to ascertain whether a market is overbought or oversold. When the price persistently touches the higher Bollinger Band, this may be an indication that the market is overbought. In contrast, when the price persistently meets the lower Bollinger Band, this may be an indication that the market is oversold.
Bollinger Bands consist of three lines overlaid on a chart. The line in the center represents a simple moving average (20-period SMA), with the outer bands representing two standard deviations from the mean.
When price movement becomes volatile, the bands widen and when price activity becomes tied into a tight trading pattern (low volatility), the bands compress (contract). Traders may identify the outer bands as profit objectives as well as points to enter a market (think mean reversion back to the central tendency).
A "swing trading strategy" is the process of entering trades and retaining them for a period of time that might range from a few days to a few weeks (a short-to-medium-term window). Technical analysis is popular with swing traders. Using indicators such as Simple and Exponential Moving Averages (SMA), the Relative Strength Index (RSI), Stochastic Oscillator (SO) are applicable for many swing traders.
Swing traders try to profit from short to medium-term trades, in between day traders and position traders.
When there has been a sustained upward or downward trend in the index prices over a few days, traders using technical analysis try to predict entry and exit points (similar to a trend-following strategy). Furthermore, swing trading requires less screen time than day trading or scalping.
How to Calculate Stock Indices
The most popular methods of computing stock index values are either a price-weighted average or a market-capitalization-weighted average. We will focus on the latter.
The total value of a company's outstanding shares of stock is referred to as the "market cap," which can also be written as "market capitalization." Both of these terms refer to the same concept. Multiplying the price of a share of stock by the total number of outstanding shares in circulation will give you the company's market capitalization. For example, a company's market capitalization would equal 1 billion dollars if it had 20 million shares outstanding and the price per share was US$50.
Formula for calculating market cap:
Example: Company Stock Index
Total Shares Outstanding
Using the formula and table from above to calculate individual market cap:
- Company 1 = $20 x 10,000,000 = $200,000,000 market cap
- Company 2 = $3 x 5,000,000 = $15,000,000 market cap
- Company 3 = $50 x 500,000 = $25,000,000 market cap
- Company 4 = $7 x 2,500,000 = $17,500,000 market cap
Total market capitalization (total market value) of the above companies, assuming only 4 companies are included in a stock index, would be as follows: $200,000,000 + $15,000,000 + $25,000,000+ $17,500,000 = $257,500,000.
Company 1 has a weight of 77.6% (200,000.000 / 257,500,000). Each of the weights can be calculated individually (weights should total 100%) to understand the influence, through its weighting, that a particular company would have on an index.
To finish the calculation, and receive an index value, the total market value (total market cap) is divided by the index divisor.
External Forces that Affect Prices in the Index Market
Various causes can influence the price movement of a market index. These include natural disasters, such as earthquakes and floods which could cause the loss of assets and property. Political turmoil is another external force investors must understand. Interest rates and geopolitical events are circumstances beyond an investor’s control and could influence prices in an Index market.
For instance, when the Federal Reserve raises the Federal Funds Rate, it "tightens" the money supply. This "tightening" serves to help keep inflation under control. Inflation also tends to increase whenever the Federal Reserve "loosens" or "eases" the monetary policy by lowering interest rates. When interest rates increase, commercial banks and consumers have to pay more money to borrow money. As a result, commercial banks typically pass these rate increases on to their customers, who may be individual consumers, small enterprises, or larger organizations. This increase in the expense of borrowing money tends to negatively influence the values of capital assets, such as stocks and bonds.
Popular Stock Indices for Index Trading
The Standard & Poor's 500 Index in the United States is first on the list (known as S&P 500 index). It determines the total market capitalization of the 500 largest companies in the U.S. This index is one of the most actively traded stock indices because of its coverage. Many people closely watch its actions, and Investors consider the S&P 500 is one of the most accurate measures of the economy in the United States.
Popular Indexes in the US:
- S&P 500.
- Dow Jones Industrial Average.
- The Nasdaq 100 Index.
- The Russell 2000 Index.
- The S&P GSCI Crude Oil Index.
The Best Indices to Trade for Beginners
Indexes have the potential to be an exceptional investment for beginners. However, as with any investment, educating yourself, and gaining a solid understanding of Indices is essential: Selecting the appropriate index and understanding the benefits and drawbacks associated with that particular index.
Before investing in an index, consider the following:
- Decide what you want to invest in and why?
- What are the potential hazards of that investment?
- How much risk are you ready to accept to accomplish that goal?
The Best Index Trading Platforms You Should Check Out
If you Google the best indices trading platforms, you will almost certainly find a listing of the best brokers. FP Markets is a fully regulated CFD broker offering various trading platforms, such as MetaTrader 4 (MT4) and MetaTrader 5 (MT5); FP Markets also include the Iress platform.
FP Markets recommend MT4 or MT5 for indices, which have customizable interfaces, and include technical analysis tools, such as drawing tools and technical indicators, one-click trading, live real-time price streaming on live accounts and demo accounts, 128-bit encryption for secure trading, plus a great deal more. Visit their website and open an account and start trading today.