How Do You Trade Indices?

How Do You Trade Indices?
INDICES

How to Trade Indices Online

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You have probably come across stock market index names such as FTSE 100, S&P 500, the Dow Jones, or DAX 30 in the news. Indices like these have increasingly become part of everyday language in the trading and investing spheres, and rightly so; their popularity is on the rise.

An index tracks and measures a particular compilation of related stocks and it’s used to evaluate the performance of a sector, a region, or a country’s economy. For example, major indices like the German Index DAX 30 measures the performance of the top 30 German companies while the NASDAQ 100 index measures the performance of a group of American companies mainly in the technology sector.

With thousands of stocks available on the various major exchanges worldwide, indices are an efficient way to reliably track and measure overall performance and market sentiment, but how do they work?

How Do Indices Work?

Generally, if the value of a stock index increases or decreases it is an indication of the overall performance of all the stocks within that particular index. However, the movement in index value is not an indication that the prices of all the individual stocks in the index are moving up or down at the same time. The value of an index is an average and while this average may be increasing, some of the individual stock may be increasing in value while the value of the others is decreasing. This particular characteristic of indices leads us to an important question.

What Are The Benefits Of Trading Indices?

Indices are a good alternative to other financial markets for several reasons. One of the biggest merits of trading indices is that unlike trading individual stocks, with indices you can benefit from the net performance of a collection of stocks. This means that if one company fails, the value of an index can still rise whereas if you hold shares in a failing business, you are likely to lose your investment. Indices provide instant diversification compared to the stock market.

Additionally, trading indices is relatively less volatile compared to trading other financial markets since no one individual stock can cause extreme price spikes. This makes the price movement of indices a lot smoother. Nonetheless, indices often reflect the broad effects of economic and political changes and so they still offer sufficient volatility for traders to find potentially profitable trading opportunities. It’s also beneficial that indices are established markets with little possible price manipulation.

However, like any financial market, indices also have some disadvantages. Some indices are less liquid than other markets. This means that some indices may be harder to trade and they may attract higher costs of trading. Furthermore, although some traders can trade after hours, index trading is generally limited to the standard stock market trading hours. As such, there may be more market gaps compared to other markets such as forex which is essentially traded 24 hours every day.

Despite these disadvantages, indices are constantly featured in the headlines of financial news, and there is the potential to earn. This means that with some good planning and work, it’s possible to capitalise on the benefits and trade indices successfully.

How Are Indices Traded Online?

Indices are purely notional and so the only way to trade them is through products that mirror their performance. Such products include futures, exchange-traded funds (ETFs), contracts for difference (CFDs), and index funds. CFDs are perhaps the most popular way to trade indices, and for good reason. These financial instruments allow traders to speculate on index price movements without taking ownership of the underlying asset.

Why Trade Index CFDs?

One of the biggest advantages of trading indices via CFDs is that, unlike traditional investing, CFDs allow you to profit in both rising and falling markets. Moreover, CFDs give you an edge compared to the other products you can use to trade indices.

For example, unlike index futures, if you trade CFDs, they have no expiration date. This means that with CFDs you can choose to keep your position open beyond certain dates or until you achieve a certain profit margin. Index futures also include elements such as a forward premium of interest which can be quite confusing.

If you have a very small trading account, trading ETFs is not as flexible as trading CFDs. CFDs are leveraged products and so you can start trading on margin which is usually only a small fraction of the required capital outlay. Put simply, index CFDs are often simpler to comprehend and trade compared to other products.

How Do You Trade Index CFDs?

Although CFDs are complex financial instruments, the right approach will increase your chances
of succeeding in the index CFD market. You can break down your approach as follows:

1. Learn the Market

Similar to other markets, it’s important to understand how things work. With index CFDs, you have to know how CFDs work in addition to knowing how indices trading works. When learning the different aspects of indices trading it’s key not to overlook the following fundamentals.

How stock indices are calculated

Before you can evaluate the performance of an index, it’s important to understand how its price is calculated. Different formulas are used to determine the price of indices, but they can be grouped into two main categories.

Market-value-weighted indices

Market-weighted indices are calculated based on the total capitalisation of its constituent companies. The majority of global indices are valued this way with FTSE 100 and DAX 30 being classic examples. Weighing by capitalisation means that the higher the total market value of a company, the larger its impact on the value of the index.

For example, let’s say the total value of all the shares in an index is $100 million. If the market capitalisation of company A is $3 million and $10 million for company B, company A is worth 3% of the index while the latter is worth 10%. This means that company B will have a larger impact on the index value compared to company A.

With the market-value-weighted system, the weight of each share is calculated as (Share price x number of shares) / market capitalisation of all shares.

Price-weighted indices

The value of these indices is calculated based on the share prices of the constituent companies in each index. In this case, the company with the higher share price will have a bigger impact on the overall index compared to a company with a lower share price. For example, a company with a share price of $2,000 will have 50 times the influence of a company with a share price of $40. The Dow Jones Industrial Average and Nikkei 225 are some examples of price-weighted indices.

How indices are analysed

Each index is slightly different from the others and so for each one, you must study details such as trading hours and weighting. It’s also important to know how indices are analysed technically and fundamentally. Using technical analysis, you can study patterns and trends to identify support and resistance levels that make for reliable indicators of future price targets and reversal points.

Using fundamental analysis, you will have to look at the elements that affect equity prices. Factors such as earnings reports and new regulations can have a significant impact on an index. Economic data can also affect the value of an index.

For example, major data releases such as unemployment figures, consumer confidence reports, and inflation data can be a huge driver of market sentiment, and in turn, an index’s performance. As such, you must be able to identify any market events which may affect price movements.

The correlation between indices and other markets

Since indices are a compilation of individual stocks, there are some important correlations between the value of indices and other related markets. The forex market is one of the related markets that can influence indices’ price movements. There is often a strong correlation between the relative strength of a country’s domestic stock index and the performance of its currency. For instance, the value of the Dow Jones index on Wall Street will likely be affected by the performance of the US dollar in the markets.

The equities market is also related to the indices market and can influence indices price movements. For example, the S&P 500 mirrors the performance of the US equity market while the DAX 30 is a valuable gauge of the German stock market. Additionally, significant changes to the share prices in a particular sector can impact indices values, especially if the sector makes up a disproportionately large part of the particular index you want to trade.

Before you start trading, it’s important to understand the constituents of your chosen index and how events in correlated global markets can affect them. Learning the market will help you avoid trading mistakes that can cost you your success in the market.

2. Find an Index with Which You Are Comfortable

Before you can trade, you need to choose an index you know well. You must understand how and why the price of your chosen index moves. When starting out in the market, you can narrow down your search for an index by using research and market news to identify the trading opportunities and volatility that different indices offer.

3. Decide on a Strategy

The best index CFD trading strategy for you depends on several factors including your risk tolerance and trading time frame. Some of the common methods you can use include:

Day trading indices

With day trading you open and close all your positions within a single day and your trades will typically last a few hours.

Scalping indices

Scalping is an ultra-short-term trading strategy where you aim to open and close trades within a few minutes. In other words, the aim is to make small frequent profits. To make significant profits you will have to make a large number of trades or trade high volumes.

Swing trading

Swing trading involves a longer time frame which can run from a few days to weeks or even months. Unlike day trading or scalping, you won’t need to monitor your position all the time with swing trading. This is because you won’t be concerned with small daily price fluctuations and you will be following a longer-term trend.

4. Choose a good broker

The quality of the broker you choose can, to a large extent, increase your chances of succeeding or failing in the market. The following are some of the top qualities you need to look for when picking a broker.

  • Security. A good broker must provide a high level of security for your funds and one good indicator of security is regulation.

  • Trading platform. Most of your trading activity will happen through a trading platform. Your broker must provide a user-friendly and stable platform that provides all the tools, information, and functionality you need to trade properly.

  • Execution. Your broker must provide good execution speeds. For instance, under normal market conditions, your broker should execute your trade at the market price you see when you place your trade, or at least at a price that is very close to your required one. Execution speed is particularly important if you’re a scalper since a few pips difference in price can make it harder to make a profitable trade.

  • Transaction costs. Every time you trade you will have to pay a fee so you must look for a broker who provides safe and reliable service for reasonable fees.

  • Ease of deposit and withdrawals. A good broker will ensure that depositing funds and withdrawing your earnings is hassle-free.

  • Support. You must pick a broker you can easily contact when problems arise.

5. Open a position and trade

Once you have chosen a broker, you can open an account and start trading in a few steps.

Step 1 | Decide on the direction in which you want to trade

Once you are satisfied with your research and market analysis you need to decide on the direction of your trade. In a rising market, you can open a long (buy) position and you can open a short (sell) position when you think that the value of an index will fall.

Step 2 | Place your trade

When you place your trade, choose a trade size that fits your budget. It’s also crucial to minimise losses and protect yourself against any unexpected volatility using sound risk management. This is because market trends are not infallible and the market can still go against you. Don’t use excessive leverage and make use of tools such as stop-losses, limit orders, and guaranteed stops.

Step 3 | Monitor and close your trade

Once you have opened a position you should stay on top of any market movements in real-time and get alerts that will help you make better trading decisions. When you want to close your position you can do so automatically or manually by placing a trade in the opposite direction to the initial one. Your position will also be closed automatically when your stop-loss and limit orders are reached.

Example | Going long on S&P 500

Suppose the S&P 500 is currently trading at 2,863.70 and your broker requires a 5% margin.

Your research suggests that the market sentiment is positive towards the S&P 500 and you decide to buy two lots with a trade value of $5,727.40. Since the broker only requires 5%, you open this position with only $286.37. Note: One lot size means that you get $1 profit or loss for every point of movement in price.

If the index subsequently moves up to 3,209.70 and you close the position, your profit will be $692 ([3,209.70 – 2,863.70] x $1 x 2). This is the profit before you account for the spread your broker charges for the trade. Conversely, if the market moves against you by the same number points, you will make a loss of $692 which is significantly more than your margin of $286.77. This is why it’s important to use leverage cautiously because it can magnify your losses as much as it magnifies your gains.

You can trade indices from all around the globe but some are easier to trade than others. To help with your search for the best indices to trade, here are some of the most popular ones.

The Dow Jones Industrial Average or US30, which is commonly known as the Dow, tracks the stocks of 30 of the biggest and most influential companies in the United States across nine sectors. It’s one of the world’s oldest and most recognizable indices and its movements are used as an indicator to gauge global risk sentiment.

The SPX500, which is commonly known as the S&P 500, is another one of the most widely known indices in the world. It includes the top 500 American companies and it was created by the publishing firm Standard & Poor’s. This market-value-weighted index has a strong correlation with other markets, making it a popular choice among index traders.

The NASDAQ is best known for representing the technology sector. Although it also includes several other sectors, almost half of the index’s stocks are in technology. The NASDAQ is the market-value-weighted index of over 2,500 securities that are listed on the NASDAQ stock exchange. The securities in the index include common stocks, tracking stocks, and real estate investment trusts.

Popular European stock indices

European stock indices represent a range of companies across the Eurozone and some of the most popular ones
include the FTSE 100, the DAX 30, the CAC 40, and the Euro Stoxx50.

The FTSE 100, which is also known as the UK 100, contains some of the biggest companies regulated by UK law and focuses on the energy, mining, oil and gas, financial services, and pharmaceutical sectors. What’s unique about this index is that not all its constituent companies are based in the UK but they are traded on the London Stock Exchange.

The DAX 30, a German stock index, comprises the 30 largest companies on the Frankfurt Stock Exchange based on market capitalisation. The DAX is among the most-traded indices due to its consistently higher volatility compared to other indices.

Similar to the DAX 30, the CAC 40 is a French stock index that is determined from the prices of the 40 largest companies on the Paris Stock Exchange by market capitalisation. Since France is one of Europe’s major economies, the CAC is widely used to assess the health of the European economy as a whole.

The Stoxx 50 is the Euronext stock index which includes the largest 50 companies from Europe based on market capitalisation. The index is often referred to as the European Dow Jones and it’s a good option if you are particularly looking to trade the Eurozone economy as a whole. The constituents of this market-value-weighted index are reviewed annually in September.

Popular Australian and Asian indices

Although less popular among UK and US traders due to different time zones, the top Australian and Asian indices
provide some good opportunities for traders.

The Nikkei Stock Exchange Index (Nikkei 225), which is also known as the Tokyo Stock Exchange Index is the most important stock index on the Japanese stock exchange and a key indicator of Japan’s economic performance. The Nikkei 225 consists of 225 companies and since Japan is an export-oriented economy, this price-weighted index is highly correlated to the US stock markets.

The AUS 200, which is more commonly known as the ASX200, includes 200 of the largest companies in Australia by market capitalisation. These companies represent a significant amount of Australia’s share market capitalisation and so the index is one way of gauging the state of the Australian market. The ASX 200 is a market-value-weighted index.

Trading Indices Online

With a good understanding of index CFD trading and continuous learning, you will be able to build your trading skills and increase your chances of succeeding in the indices market. Furthermore, trading indices will help you track the economic performance of different countries and sectors and you can capitalise on this knowledge when diversifying into other markets such as currency trading.

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