Indices Trading

What is indices trading?

In essence, indices are the measure of corporate performance or an overall economy. Indices trading - also known as “market-based trading” is a way to trade indices by buying stocks from one index and selling it against another index in order to profit from the relationship between them.

Index trading is when you buy and sell an index. Investors will bet on the price going up or down. If it goes up, they'll buy; if it goes down, they'll sell. You won't buy any stocks, but you will be buying the average of all of them instead. When some go up, the index goes up. When others go down, the index goes down.

You can trade indices in three different ways – futures, options and CFDs. A future is like an agreement to buy or sell at a certain price on a specific date in the future; an option gives you the right to choose between buying (a call) or selling (a put) at a specific price on the same date. A CFD (Contract for difference) is like a future, except you don't have to own anything until you close your position, at which point, if you make money, you get paid. You can also use spreads and combinations of all of those things to generate returns from indices.

When you trade indices online, there are two main types: index cash CFDs and index futures CFDs. The main difference between the ‘cash’ market and ‘futures’ market is that the ‘cash’ does not have an expiry date. The ‘futures’ market, however, has an expiry date, normally known as a ‘rollover’.

A futures contract is effectively an agreement between the buyer and the seller on the price that has to be paid by the buyer at a given future date.

What are the major world indices?

There are many indices, but traders typically focus on the largest and most globalised ones. Many of them include blue-chip stocks. Blue-chip can be defined as a well-established company with a market cap in the billions and considered a market leader. Some of the largest indices traders focus on are:

• S&P500 (Standard & Poor’s 500 Index) is one of the most popular. It holds 500 leading companies in their respective industries (from technology and finance to healthcare). It includes such blue-chip companies as Google, Apple, Microsoft and Walmart. This index is considered a leading indicator of the US economy.
• NASDAQ100 is the second most popular index, just behind S&P500. It’s a market-value weighted stock market index made up of 100 largest non-financial companies listed on the NASDAQ exchange. All stocks in this index are bought and sold through derivatives trading (CFDs, futures and options).
• FTSE100 is the third most popular index. It’s a capitalisation-weighted stock market index made up of 100 largest companies listed on the London Stock Exchange. All stocks in this index are bought and sold through derivatives trading (CFDs, futures and options).
• CRSP US Total Market Index is the oldest index. It’s a market-value weighted stock market index made up of almost all common stocks outstanding in the US. As you would expect from its name, it holds every company listed on any major exchange in the US.
• MSCI World is an index that covers around 85% of all the world's stock markets. It provides exposure to stocks across 23 developed and 24 emerging markets. This index has no country- or currency-weighting restrictions, which means that its performance reflects the size of companies in individual countries and regions, not their home government or central bank.

What moves index market prices?

The movement of index prices is primarily dependent on external forces. The price will generally decrease in times of uncertainty that bring weakness to the relevant country's economy.

Some factors that can impact the price of an index include:

• Corporate earnings reports: individual companies’ opinions about industry performance.
• International policy changes: when two countries make a decision that affects their respective economies, it will most likely impact the index of one or both those countries.
• Changes in interest rates: some central banks may change interest rate policies to stabilise their economy. If the interest rate goes up, it attracts capital inflow into the country and will increase the index.
• Changes in domestic policies: if new laws are introduced that are beneficial to economic growth, then this could also impact on index prices.
• Inflation: if inflation rises in a country, it may have an adverse impact on market sentiment and cause investors to re-think their investment strategy.
• Employment reports: unemployment figures, as well as the number of jobs created, will affect investors' view on the economy and accordingly index prices.
• Political risk: stock markets around the world are usually volatile during times of conflict or political instability (e.g.: Brexit).

Benefits of index trading

There are several reasons that stock indexes have been popular amongst beginner traders and experienced investors for many years.

As an investor, you can own a little of almost anything. For instance, if you wanted to have exposure in the oil and gas sector but don’t want 70% of your portfolio to be tied up in one company, then you could purchase an index ETF that tracks this sector.

A wide variety of professional traders (money managers) use indexes for their value. These professionals study and analyse the markets using these tools to determine where they should place trades.

The information we get from indexes is often much more accurate than individual company reports or economic indicators, because an index represents a basket of various stocks within an industry or country. For example, if you wanted to know how the stock market is doing overall, you would not just look at manufacturer XYZ’s report and assume the stock market has done well; you would instead want to take a look at an index that includes all of the performing companies on the stock exchange.

This may seem like a minor point, but if one of your investments tanks and ends up losing a substantial amount of money for you, the impact on your overall investment portfolio is much less than losing all of one stock in an index.

From a trading perspective, indexes are easy to trade because they are liquid and have constant volume. This allows traders to get into and out of trades quickly without having to worry about their order getting chopped or taken out at a bad price.

Since indices represent an entire sector of the market, it allows investors to gain exposure to various industries without having to do a lot of research and analysis on individual company stocks.

Risks of indices trading

There are also some risks involved with trading indices, but in the most part they can be managed by being aware of them and taking the appropriate action to manage those risks.

The biggest complaint about trading an index is that if one company goes bankrupt or encounters a major problem that threatens its ability to continue as a going concern, you will feel the full force of this problem. This means that if a company that represents 5% of the index goes bankrupt, it is as though you have lost 5% of your investment.

Some would argue that when you invest in an individual stock, you are exposed to the same risk of loss -- but there is one major difference: A single company’s failure will not have a drastic effect on an individual stock’s performance, but when one company in the index goes bankrupt, investor sentiment tends to spread to other companies in the index and it can cause major losses.

The other main concern with indices trading is that some are expensive to trade because of their popularity. For example, if you were to go online and try to purchase an individual stock (instead of buying an index), there is a good chance that this stock will be listed on several different websites, with varying prices. This makes it easy for you as the investor to buy at the lowest price available.

Conversely, when trading an index, other traders are also going through the same process of buying and selling this same index -- and the result is that price may be slightly higher than what it would be if you were to trade an individual stock.

The solution to this problem is twofold: One, check for liquidity; some popular indices have a lot of trading volume (liquidity) which will keep the spread tight between bid and ask prices.

And two, take the time to find out if there are any hidden charges involved with this particular index.

Now that you have a better understanding of Indices Trading - consider Global Prime for your next trade.