Index Trading Strategies: A Guide to the Stock Indices

February 04, 2021 11:10 UTC

If you read articles about economics or trading, you will have likely come across the term “stock index”. But what is a stock index? Can we learn anything from them? What are the most commonly traded indices? And are there any index trading strategies? In this article we will answer these questions and more!

Index trading strategies

What Is an Index?

An index is a tool used to track the performance of a group of financial assets. Indices are designed to represent, or track, a particular industry or market. Some of them are broad based indices, which attempt to replicate a market, and some are more specialised ones, which attempt to capture an individual segment of the market.

When you hear the term “index” in trading, it will usually be preceded by the word “stock”. A stock index refers to one of these so called broad based indices, which represents an entire stock exchange. 

Benchmark Indices

Every stock exchange in the world has a “benchmark” index and so too does every country, some countries having more than one. 

Benchmark indices aim to represent, or track, the performance of the market they cover as closely as possible. They are used by economists, investors and analysts to understand how that particular stock exchange, or country, is performing.

Below is a list of four of the most popular benchmark indices in the world:

  • S&P 500
    • The Standard & Poors 500 is a US stock index which includes the 500 largest companies listed on the New York Stock Exchange and the NASDAQ
  • FTSE100
    • Otherwise known as the Financial Times Stock Exchange 100, the FTSE100 includes the 100 largest companies listed on the London Stock Exchange
  • NASDAQ100
    • This index represents the 100 largest technology companies listed on the US NASDAQ stock exchange
  • DAX30
    • The DAX comprises of 30 major German companies which are listed on the Frankfurt Stock Exchange

These benchmark indices represent the most frequently traded stock indices in the world. If you are looking for liquidity when it comes to index trading strategies, these are the best indices to trade.

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Types of Index

In the past, many market indices gave equal weighting to the stocks which they consisted of. Whilst some indices remain calculated this way (e.g. the Dow Jones Industrial Average), it can be more representative of the market, and has become more common, for different stocks to be assigned a different weight within the index. 

Changes in stocks which have a higher weight in the index will influence the overall price of the index more than stocks which are assigned a lower weight. There are four common ways which indices are weighted, which we will explore in the following sections.

Share Price

The share price weighted average takes into account the individual share price for each company in the index.

Market Capitalisation

These indices use market capitalisation to determine the weighting of each stock. Market capitalisation is the total value of all outstanding shares of a company. The larger the market capitalisation of a member of the index, the larger is weight will be,

Free Float Capitalisation

Here, the index takes into account each member’s free float market capitalisation. This is calculated by multiplying the individual share price by the number of shares which are freely traded on the stock exchanges.

Revenue

Revenue weighted indices take into account a company’s total annual revenue when assigning weighting. This method is seen by some as more reliable than measures which rely on share price, as share prices can often be under or overvalued.

Why Trade Stock Indices?

Trading stock indices provides instant diversification, which is a great way of reducing some of the risks associated with trading. When purchasing shares in a company, your invested capital is at the mercy of the performance of that individual company. 

Profiting from trading stock indices, however, does not rely on the success of any one company, but rather the collective success of numerous companies. Therefore, if an individual company performs badly it is not likely to drastically affect the price of the overall index, unless the company is assigned a particularly large weighting.

For the same reason, stock indices experience significantly less volatility than the shares of individual companies. Although some see volatility as an opportunity to profit, other traders steer clear of volatile markets due to the increased level of risk it brings.

How to Trade Indices

As we have explained above, indices are indicators of the price movements of a basket of financial assets. As such, an index has no physical value. 

Therefore, it is not possible to trade an index directly, instead a trader will need to use derivative products to take advantage of movements in the index. “Tracker” funds, Contracts For Difference (CFDs), futures, spread betting and Exchange-Traded Funds (ETFs) are all such derivative products which can be used to trade stock indices.

Trading indices via CFDs allows you to profit from both rising and falling prices, as well as benefiting from the use of leverage.

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What Drives an Index’s Price?

An index fluctuates in value along with the collective value of the stocks within it. So, each time the price of a constituent share rises or falls it will have an impact on the value of the index, proportionate to its weighting in the index.

In order for the price of an index to significantly increase or decrease, something needs to have happened to cause the price of a significant number of the constituent shares to change. Before you are able to construct index trading strategies, you need to understand the fundamental events which can influence their prices.

Economic or Fiscal Announcements

Economic and fiscal announcements can influence a stock index’s score. Examples of such regular announcements are:

  • Gross Domestic Product results
  • Latest unemployment data, such as the Non-Farm Payroll in the US
  • Central Bank announcements regarding interest rates

These announcements only tend to affect stock indices significantly when the announcements differ greatly from what was expected. For example if a country’s latest GDP data is far worse than the forecast, this will negatively impact an index.

Using an economic calendar is the best way of keeping track of any scheduled economic announcements.

Government Policy

Any changes in government policy which positively or negatively affects individual sectors or the economy as a whole will likely impact the stock indices.

Example: A Government Announcement Regarding Economic Policy

SP500 M1 ChartDepicted: Admiral Markets MetaTrader 5 - SP500 M1 Chart. Date Shown: 6 October 2020. Captured: 14 October 2020. Past performance is not necessarily an indication of future performance.

In the chart of the S&P 500 above, the red vertical line indicates the time at which President Donald Trump made an announcement via Twitter that he was ending negotiations over a new economic aid package. This package was intended to provide much needed assistance to the US economy in the wake of the coronavirus pandemic. Trump’s unexpected announcement caused the S&P 500 to drop more than 2% over the following 19 minutes.

Foreign Exchange

Major changes in the value of the domestic currency can change a stock index score either positively or negatively. A drop in the local currency will benefit exporters and negatively affect importers. Therefore, the effect of a change in currency will depend on the balance of these two groups in the index. 

For example, the FTSE100 is dominated by exporters, so when the British pound falls, the index tends to rise.

FTSE100 Daily ChartDepicted: Admiral Markets MetaTrader 5 - FTSE100 Daily Chart. Date Range: 4 September 2018 - 11 January 2021. Date Captured: 11 January 2021. Past performance is not necessarily an indication of future performance.

Health of the Economy

We mentioned earlier that benchmark indices can be used to evaluate how a particular economy is performing. For example in the US, the S&P 500 is usually referenced when discussing the health of the US economy. 

This is because the overall health of the economy will impact the price of an index. To continue with our example, when the US economy is under or overperforming, this will be reflected in the share prices of constituent stocks and, therefore, in the overall score of the index.

Performance of Particular Industries

If a particular industry makes up a large percentage of an index’s members, then any change in the health of this industry will likely impact an index.

For example, the S&P 500 tends to be heavily influenced by tech stocks. Therefore, if this industry is adversely impacted, so too will the S&P 500.

Index Trading Strategies

In order to create trading strategies for stock indices, you need to firstly decide what type of trading style you are going to use.

  • Scalping
    • This style of trading uses the shortest time horizon. Scalpers hold positions for minutes, or even seconds, aiming for just a few points of profit at a time, the logic being that if they make enough trades a day, the few points will add up to a greater profit.
  • Day Trading
    • Day traders also work in the short-term, not holding positions beyond the end of the trading day.
  • Swing Trading
    • Swing traders work in the medium to long-term, trying to get the most out of swings in price. They will hold positions for days, weeks or even months.
  • Long-Term Trading
    • These traders will invest and then hold their position for an extended period of time, seeking to make a steady profit.

Scalpers thrive on volatility in the financial markets and, it must be said, that in times of economic stability, indices tend to have fairly low volatility. Whilst there will be some opportunities to trade the stock indices for scalpers, they would be better suited in more volatile markets, such as the Forex market.

The next few sections describe how you can incorporate simple index strategies into your trading and investing.

Position Trading

Position trading is a strategy for long-term traders and essentially consists of taking a position in the market and holding it.

This strategy can be effective in benchmark indices during economic stability, as the indices will tend to grow steadily.

Passive Index Tracking

One of the most important investment trends in the last two decades has been the proportion of money that gets invested “passively” through “tracker” funds and ETFs.

Tracker funds or ETFs try to track the performance of well known indices, like the S&P 500 or the Dow Jones Industrial Average (DJIA), by buying the underlying constituent stocks or their derivatives. 

Passively following indices, instead of picking individual stocks, means you can avoid the cost of hiring expensive fund managers and analysts and all the infrastructure those people need to do their jobs.  

As such, passive investing can be a low-cost, low-hassle way of investing in the markets.

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Hedging

Let’s assume that the date for Apple’s annual results announcement is coming up. You’ve done some analysis and you are convinced that the results are going to be fantastic and that this will lead to a substantial rise in Apple’s share price. 

Naturally, you want to “go long” on Apple by buying shares, or with CFDs, so that you can profit from the rise you expect from the shares.

At the same time, you think the economy is looking a bit fragile and the stock market as a whole is looking somewhat “toppy”. You are worried that any negative piece of news might drag the whole market down, and Apple with it (this is called “market risk”).

One way to proceed would be to go long on Apple and then to protect yourself against the market risk by shorting the most relevant market index, the S&P 500 in this case. 

Protecting your trade in this way is called “hedging” and it is a very popular strategy among professional traders and the origin of the term “hedge fund”.

FX Moves as a Trading Signal

Large currency falls help exporters and hinder importers - and vice versa.

By understanding the composition of a specific index, it is possible to predict how the index will react to large movements of the domestic currency.

As we noted earlier, the FTSE100 is dominated by large exporters, so whenever there are large falls in GBP, the FTSE100 tends to rise.

FX is the most liquid, most global, most widely traded market around the world - and it trades 24 hours a day 5 days a week. As such, large FX moves can act as early signals to buy or sell stocks and indices.

Trading Economic Events

Some economic news, like a sharp rise in interest rates for example, will be positive for one or two companies but negative for the market as a whole.  The opposite can also be true.

At times like this, you can take a position in the market and avoid having to analyse individual stocks by taking a position in the relevant index. 

Trading Time Zones

A similar strategy is to trade the time-zones. 

In today’s interconnected economy, what happens in one part of the world can affect markets in other regions. As the trading day moves westward around the world, big events or market moves in Tokyo or Hong Kong will have an impact on the market in London and, later, New York.

If there is a big fall in Asia, by starting early, you can have time to digest the news and prepare to short the London market before it opens. 

Similarly, if events in European markets are dramatic enough that you think they will impact the US markets, you can place your orders before the US markets open.

Again, by using an index like the FTSE100, or the S&P 500, you can avoid the work involved in analysing individual stocks.

Final Thoughts

You should now be familiar with what stock indices are, the different types of index and some index trading strategies.

Stock indices represent an interesting opportunity for traders to attempt to make a profit from the stock market, without heavily researching a company’s fundamentals. The diversification they offer also means that trader’s do not have “all their eggs in one basket”.

However, there are some drawbacks to trading stock indices. There is not a lot of volatility, which means that some traders, particularly scalpers and day traders, would be better suited to other markets. It is also only possible to trade stock indices during the times at which the relevant stock exchange is open.

If you are new to trading, you should practice any index trading strategies on a demo account before you put your money at risk on the live markets.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

Roberto Rivero
Roberto Rivero
Financial Writer, Admirals, London

Roberto spent 11 years designing trading and decision-making systems for traders and fund managers and a further 13 years at S&P, working with professional investors. He has a BSc in Economics and an MBA and has been an active investor since the mid-1990s