How to trade indices

Introduction

Indices are probably the most important market for retail investors. For 30 years or more, a greater and greater portion of total invested assets has flown into large passive funds that exist only to replicate the returns of a well-known index. These indices track the performance of baskets of stocks, and they are arranged in a dizzying number of combinations in terms of sector, geography, and market capitalisation. Most stock exchanges have a headline index that shows the overall performance of the top assets listed on their exchange, and there are even multinational or global indices that track stock markets worldwide. Day traders use indices to speculate on price moves in national stock markets, as they avoid the concentration risk of single stock CFDs. Indices are typically quick to respond to world events or economic announcements, and they can be traded using the same technical indicators as any other asset class.

“Indices are used as a barometer of the overall economy they track, as a benchmark for active fund managers to beat, or as investible assets in their own right, traded via ETFs, mutual funds, or CFDs on indices”

What are indices?

Indices are securities that track the price of a basket of stocks. Indices measure the overall performance of this basket, providing a return based on the percentage gain or loss in the overall average of the index, which may be weighted or unweighted. The biggest stock indices are famous worldwide, like the Dow Jones Industrial Average (DJIA) or the S&P500 – the two headline indices for the US stock market. Indices are used as a barometer of the overall economy they track, as a benchmark for active fund managers to beat, or as investible assets in their own right, traded via ETFs, mutual funds, or CFDs on indices.

How to trade index funds

Index funds can be bought and sold like single stocks, and ADSS CFD traders are able to share in their price action without taking ownership of the underlying assets. This also means you have the ability to short indices, something not possible in the general market. For example, if you believe that an economic announcement or event could negatively impact the overall US economy, you could short the Dow Jones and profit from any negative price action. Remember to use stringent risk management protocols including stop losses when taking out short positions, either on stocks or stock-like assets such as indices, because the theoretical losses in a short trade are unlimited.

Types of index funds

Index funds are divided into categories based on the stocks they include. The most common criteria are size and geography – for example, the S&P500 only includes American companies, while the FTSE100 only includes British companies listed on the London Stock Exchange. This allows traders to use indices to express a view on a single country, for example trading political risk around an election. Because the S&P500 is divided across 500 different companies in different sectors, it offers a broader view of the overall market than the concentrated 30-stock DJIA, making it a more reliable indicator of US economic performance. Each index is weighted and calculated differently, so you should take some time to understand how it is structured before trading

Popular index trading strategies

Index trading lends itself well to both technical and fundamental strategies. Learning how to trade index funds involves understanding both how economic and political events can impact national economies as well as using the patterns seen in price action. Most index traders use fundamental or news-based analysis to select indices they think may under or over perform, then use technical analysis to enter and exit an intraday position in that direction.

Technical analysis: trend following

Technical analysis is a popular approach for trading indices, relying on chart patterns, indicators, and historical price data to make trading decisions. One common set of strategies are referred to as trend following, where traders identify the overall direction of an index using moving averages or trendlines, and join in the direction of the trend. They may enter long positions during uptrends and short positions during downtrends. Support and resistance levels are also crucial in index trading, as these price points often act as barriers where the index may reverse direction. Traders look for breakouts above resistance or breakdowns below support as potential entry signals. The more times the market ‘tests’ a support or resistance level, the stronger technical analysts consider it to be.

Technical analysis: mean reversion

Another widely used group of technical strategies are collectively called mean reversion strategies. These strategies try to identify the point where a trend is about to fail, and a new trend begin in the opposite direction. Because it involves trading against the existing trend, some analysts consider these strategies riskier. Common ways to identify a failing trend involve using oscillators like the Relative Strength Index (RSI) or Moving Average Convergence Divergence (MACD) to identify overbought or oversold conditions. Traders may look to enter short positions when an index appears overbought or long positions when it seems oversold. Additionally, many index traders employ volume analysis to confirm price movements and gauge the strength of trends

Fundamental analysis

Fundamental analysis for index trading focuses on macroeconomic factors and news events that can impact entire markets or sectors. Economic indicators play a crucial role, with traders closely monitoring data releases such as GDP growth, employment figures, inflation rates, and central bank decisions. For example, strong economic data may lead traders to take long positions in a country’s main index, anticipating overall market growth. When fundamental traders do this, they are relying on that index to act as a proxy for overall economic activity, something that doesn’t always hold true. When it comes to short-term market reactions – the type of price moves CFD day traders are most interested in – this doesn’t matter. Rotations into and out of the index based on sentiment will create short term moves in the expected direction, but longer-term traders need to bear in mind the different between the index and the national economy. For example, the FTSE100 includes many businesses who generate the majority of their profits overseas. That means it is not a perfect proxy for the UK economy.

Events and news-based trading with indices

Geopolitical events and policy changes also factor into fundamental index trading strategies. Elections, trade agreements, regulatory shifts, or international conflicts can significantly influence market sentiment and index movements. Sector analysis is another important aspect, as some indices are heavily weighted towards specific industries. For instance, a trader might go long on a tech-heavy index like the NASDAQ if they anticipate strong performance in the technology sector based on earnings reports or industry trends. Fundamental traders also consider global market correlations, often using the performance of one major index as an indicator for potential movements in others.

How to trade indices: a practical guide

To trade indices, the first thing you need is a trading account. Consider running a demo account at first, so you can familiarise yourself with the trading platform and market price action before risking your capital. Once you’ve opened your account and funded it, you are ready to begin trading. You probably have an idea which indices you are interested in trading already – if not, browse through the assets on offer and learn more about the different indices available. The best way to learn is by doing, so – ensuring you use stop losses and position sizing appropriate to your overall portfolio – once you have set this up, you are ready to start trading global indices with CFDs today.

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