What is index trading and how to trade indices?

What are indices?

An index is a way to measure the performance of a group of assets. In trading, this involves publicly traded companies and their stock prices.

One of the best-performing and most widely known indices in the world is the Dow Jones index. The Dow Jones Industrial Average (DJIA) tracks the overall performance of the 30 largest companies in the US. If the average price of the 30 companies goes up, the DJIA also climbs higher. If the average price of the 30 companies drops, the DJIA will decline too.

What is the indices market?

The indices market is the market where indices and related financial products are traded. This market is made up of top-performing groups of individual indexes from different countries and representing different sectors.

Below is a list of the most popular indices in the world. Many of them include “blue-chip” stocks. Blue-chip companies are typically well-established, considered to be market leaders in their sector, and likely to have a market capitalisation value in the billions of dollars.

• Dow Jones Industrial Average: One of the leading US stock indices, consisting of 30 large, US-listed companies.
• S&P 500: America´s most famous stock index, consisting of the 500 largest companies listed on stock exchanges in the United States.
• EURO STOXX 50: Represents 50 blue-chip companies listed within the eurozone. It can be seen as the eurozone´s version of the Dow Jones index.
• Nasdaq 100: One of the world´s most watched indices, consisting mostly of heavyweights in the technology sector. Despite its name, it actually consists of 101 securities issued by the 100 largest non-financial companies listed on NASDAQ.
• FTSE 100: An index representing the 100 companies listed on the London Stock Exchange with the largest market capitalisation.
• DAX 40: Germany´s most important stock index, consisting of 40 major blue-chip companies listed on the Frankfurt Stock Exchange.
• CAC 40: An index representing 40 major blue-chip companies listed on Euronext Paris.
• Nikkei 225: Japan´s leading stock index. It is a price-weighted index and tracks the performance of 225 large companies listed on the Tokyo Stock Exchange (TSE).
• Hang Seng: Tracking the performance of 73 large companies listed on the Hong Kong Stock Exchange.
• ASX 200: A benchmark index for the Australian stock market. It consists of the 200 largest stocks listed on the Australian Securities Exchange, measured by market capitalization.

What is index trading?

Index trading is the buying and selling of a specific stock market index. Traders speculate on the price of an index rising or falling, which then determines whether they will be buying (going long) or selling (going short).

It is important to understand that an index only represents the performance of a group of stocks, and trading indices does not mean you are buying any actual underlying stock to take ownership of. Instead, you are trading the average performance or price movements of the group of stocks. When the price of shares for the companies within an index goes up, the value of the index increases. If the price instead falls, the value of the index will drop.

To understand what index trading is, we need to explore the factors behind the price movement.

The movement of index prices is primarily dependent on external forces. The price will 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:

• Global news: Events such as natural disasters, pandemics, political instability, conflicts, and wars can all have a major impact on indices. It could be confined to only one country (e.g., an earthquake in Japan) or it could have a global impact (e.g., a war between two or more countries).
• Economic news: Economic events and meetings such as central bank rate decisions, non-farm payrolls, trade agreements, and employment indicators can have a major impact on indices. Some could be specific to only one index; for example, UK employment numbers would primarily impact the FTSE 100 (Britain´s main stock index). Other events, such as the meeting of the US central bank, could impact indices all around the world because the USD is the dominant global currency.
• Index reshuffle: When a company's stock is added or removed from a stock index, it can impact the price of the index. Generally, a reshuffling of the index is beneficial for investors, as it ensures only relevant companies remain part of the index. One example is the once-famous photography company Kodak. It was a part of both the Dow Jones 30 and the S&P 500 for a long time but was eventually dropped from both indices as it continued to struggle, and its market capitalization shrank.
• Company news: Earnings results, mergers and acquisitions, changes in leadership, and other major company-specific news can all affect the index of which the company is a part. The higher the weight of the company, the more impact the news will have on the index. For example, Apple announcing much better than anticipated earnings numbers would have a positive impact on both the S&P 500 and the NASDAQ 100.

How does index trading work?

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 market 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 must be paid by the buyer at a given future date.

There are two main types of indices you can trade:

• Index cash CFDs: Featuring tighter spreads based on spot pricing, cash indices are more suitable for short-term traders. Cash CFD (Contract for Difference) traders tend to avoid holding positions overnight to avoid paying overnight trade charges and will reopen trades the next day.
• Index futures CFDs: With a contract based on a price for future delivery, Index Futures CFD trades are preferred by traders interested in medium- to long-term trading. This is because this type of trade does not incur overnight funding or swap charges.

An example of index CFD trading:

Let us assume that the FTSE is currently trading at the 6659.97 level.

Your technical indicators suggest an entry signal, with the belief that the market sentiment is positive towards the FTSE, and you decide to purchase one lot. This position size has USD$1 of profit or loss for every point of movement in the price.

Two days later, as you anticipated, the FTSE has pushed higher and is trading at 6701.97. Now, your profit is calculated by subtracting the opening price from the closing price:

(6701.97 - 6659.97) x USD$1 = USD$42.

Note: In the above example, profit and loss are calculated in the currency of the region that the index is tied to. However, with most brokers, the profit and loss are automatically converted to your chosen account currency in real-time, based on the current exchange rate.

What is the best time to trade indices?

There are certain time periods throughout the trading week where market volumes and prices tend to be more active as the market factors in all the news and events since the previous close. For experienced traders, the interval between 9:30 and 10:30 a.m. ET is one of the best hours of the day, as it offers the biggest moves in the shortest amount of time.

You should also consider that different indices are traded at separate times, depending on the individual exchange. If you are new to trading, you may want to consider avoiding trading during these hours, when high volatility may cause rapid price fluctuations. However, this can also be the ideal time to learn by observing and analysing market behaviour.

The optimum time to trade is simply when the markets open in different time zones. Because index markets do not operate continually like the currency market, you must choose the optimal time to open a trade.

Why trade indices?

Indices give you the opportunity to trade the direction of the stock market as a whole.

For example, if you expect that the US is heading towards a recession and that the domestic stock market will decline, it would be inefficient, inconvenient, and expensive to enter short positions on many individual stocks. Instead, you could place a single CFD short position on the Dow Jones 30 and profit from any potential downturn in the index.

Indices also provide diversification. You may feel comfortable trading only one asset class (like forex), but if you find yourself in a situation where your strategy is not working anymore, for example, due to a lack of volatility, it could be an opportunity to test your strategy on other products.

Indices are highly liquid, which means they are suitable both for short-term and long-term trading.

How to trade indices

Indices are accessible to anyone with an internet connection and a computer or smartphone. Trading indices can be done five days a week, and it is possible to get started with a little money. Here is a quick, step-by-step guide on how to trade indices:

1. Choose a reputable broker: Look for a broker that is licenced and regulated, has a good reputation in the market, and offers the full range of indices you want to trade.
2. Open a trading account: Once you have chosen your broker, you need to open a trading account. This should be a simple and free process. Note that a reputable broker will require you to verify your ID as part of security and fraud protection.
3. Fund your account: Once your account is verified, you will need to deposit funds that you can use to trade with. Most brokers accept deposits in common currencies, including USD, EUR, and GBP.
4. Choose an index to trade: Once your account is funded, you can choose the index you want to trade. Popular instruments include the Dow Jones 30, S&P 500, DAX 40, and FTSE 100.
5. Determine your trading strategy: Before you place a trade, you need to decide on your trading strategy. This involves deciding how much you want to invest, setting stop-loss and take-profit orders, and determining your risk tolerance. You should also consider how much you are prepared to lose if a trade goes against you.
6. Place your trade: After deciding on your trading strategy, you can place your trade. This involves selecting the amount you want to invest, choosing the direction of the trade (buy or sell), and setting your stop-loss and take-profit orders.
7. Monitor your trade: Once you place your trade, you need to monitor it to ensure that it is performing as expected. You can close your trade at any time, either to take profits or to limit losses.

As a general guide, if you are new to indices trading, it is important to educate yourself on how the market works and the risks involved. You should also strongly consider starting your investment journey with a small amount of money that you are prepared to lose if the trades go against you.

Advantages of index trading

There are several reasons why indices have been and continue to be popular among beginner traders and experienced investors for many years. These include:

• Broad market exposure: Trading indices allows you to gain exposure to a diversified basket of stocks or assets, providing a snapshot of the overall market or a specific sector.
• Flexibility: Indices trading offers flexibility in terms of trading strategies. The ability to go long or short means you can take advantage of stock indices’ falling or rising prices.
• Less capital needed: Minimal capital is required to start index trading, and the costs are lower than trading the actual futures contract.
• One trading account: You only need one trading account to access multiple indices from all over the world, including the ASX 200, Dow Jones, Hang Seng, Nikkei 225, and DAX 30.
• Diversification: Index trading allows for diversification by spreading your investment across multiple securities, reducing the impact of individual stock performance on your portfolio.
• Accessibility: Index trading provides access to markets that may be difficult or too costly to access directly, such as international markets or specific sectors.
• Lower transaction costs: Compared to trading individual stocks, trading indices incurs lower transaction costs, as you can gain exposure to a broad range of securities through a single trade.
• Leverage: Many index trading products, such as futures and CFDs, offer leverage, allowing you to control a larger position with a smaller amount of capital. This amplifies both potential profits and losses.
• Liquidity: Major indices typically have high liquidity, meaning there are many buyers and sellers in the market. This allows for the efficient execution of trades with minimal slippage.
• Hedging: Trading indices can be used for hedging purposes to offset potential losses in other parts of your portfolio. For example, if you have a stock-heavy portfolio, you can use index futures to hedge against overall market downturns.

Disadvantages of trading indices

• Volatility: Indices trading can be highly volatile, subject to sudden and significant price fluctuations. This volatility can lead to substantial gains or losses, depending on market conditions.
• Limited trading hours: Index trading typically follows the market hours of the exchange on which the index is listed. This means traders may face limitations in terms of when they can enter or exit positions, which can be a disadvantage for those who prefer to trade outside traditional market hours or other markets, that trade 24/7.
• Higher risk of gaps: Since indices are not open 24/5, the risk of major market gaps is higher than in forex. Some traders therefore prefer to close their positions ahead of the market close.
• Leverage risks: While leverage can amplify profits, it also increases the potential for substantial losses. Inexperienced traders may find it challenging to manage the risks associated with leverage.
• Lack of control: As indices are composed of multiple stocks, traders have little control over the individual components' performance. Even if an individual stock within an index performs exceptionally well, its impact on the overall index may be minimal, or vice versa.
• Lack of fundamental analysis: Index trading often relies more on technical analysis and market trends than detailed fundamental analysis of individual stocks. This can limit traders' ability to identify undervalued or overvalued stocks based on their financial performance or other company-specific factors.

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This information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. It has been prepared without taking your objectives, financial situation, or needs into account. Any references to past performance and forecasts are not reliable indicators of future results. Axi makes no representation and assumes no liability regarding the accuracy and completeness of the content in this publication. Readers should seek their own advice.