Tips to Help with Index Trading

See also: Understanding Investing

Index trading is a form of stock market investing. It relies on the existence of stock market indices, which track the performance of a big group of shares. Examples of familiar indices include the FTSE100, and the S&P 500. Both these track groups of stocks. The FTSE100 (also known as the Footsie) tracks the 100 stocks with the biggest market capitalisation listed on the London Stock Exchange. The S&P 500 tracks the 500 largest companies in the US.

Investing in indices or funds that track an index can help to limit the risk to which you are exposed, because this evens out rises or falls in one particular stock. However, you can also trade in instruments (futures) that make ‘bets’ on which way the index will go (up or down), which is slightly riskier.

Index Trading

What is Index trading? Indices are effectively baskets of shares—but how you can trade them?

Index trading means buying and selling financial instruments that are linked to the prices of indices. These include, for example, funds that track a particular index. These funds tend to hold shares in a similar proportion to the index. Passive funds try to match the performance of the index. Active funds are actively managed to try to outperform the index.

Funds are a good way to start investing, because it diversifies your stock holding, and therefore reduces your risk. However, this reduced risk also means that your returns may be less. Many people therefore use other options.

Types of Index

There are various different types of index, and they may also be compiled in different ways.

For example, an index may be a simple average of all the stocks it includes. Alternatively, it may be weighted so that changes in the price of certain stocks have more effect on the overall index value. Some are weighted towards bigger companies, or higher market capitalisation.

Indices may also measure different things, including:

  • A stock index, such as the FTSE100 measures the price of stocks and shares.

  • Commodity indices track the prices of commodities, such as gold, oil, or sugar. One example of a commodity fund is the United States Oil Fund, which tracks the price of West Texas Intermediate crude oil.

  • A bond index measures the performance of part of the bond market. Bonds are defined as promises to pay issued by governments or companies, and are ways for these organisations to borrow money.

  • Currency indices track the price of a particular currency against other currencies.

Indices may change value in response to many factors.

The individual share prices of the stocks included will of course have an effect. These may be affected by company announcements such as the publication of year-end accounts or financial statements. However, the whole index may also be affected by larger macroeconomic factors such as the global economic climate, or government announcements that may affect national economic positions.

Three Ways to Trade Indices

1. Cash indices

This is effectively trading directly on the index itself.

Cash indices directly measure the value of a basket of shares. The FTSE100 and S&P 500 are both cash indices. People tend to trade these when they want to buy and sell in a very short space of time, because there are additional changes for overnight holdings.

2. Index futures

This is betting on the future movements of the index or indices.

Index futures are financial products that vary in value depending on whether traders think the index value is going to rise or fall. They last for a particular period of time, after which they expire. On expiry, you can settle for cash, or extend them for a new period.

Contracts for Difference (CFDs)

Contracts for difference are another way to bet on the future movement of the index. They are contracts between broker and trader that speculate on the price difference between when an index opens, and when it closes.

A long position is taken when you expect prices to rise, and a short position when you expect prices to fall.

Contracts for difference are fairly risky investments, because they are leveraged. However, that also means that your returns can be greater for a smaller initial investment.

Trading on index futures means that you can make money whether the index rises or falls—provided you make the right prediction.

3. Exchange-traded funds

These are funds that track an index, but are also themselves traded on the stock exchange.

They are usually weighted similarly to the index, so that their price fluctuations are expected to follow those of the index. This doesn’t always follow, and some fund managers aim to out-perform the index, rather than simply passively follow it.

Developing a Strategy for Index Trading

Before you start index trading, it is probably helpful to develop a strategy for it.

You need to be clear about the basis for your investments and trades. This will help you to avoid the temptation to sell or buy based on immediate price fluctuations.

One of the most common strategies is trend-based. This uses indicators such as price trends to assess direction of travel and likelihood of change, and momentum indicators to assess the strength and speed of movement. This will help you to assess which indices to consider, and when to buy and sell.

You can also identify limits on your investments. For example, you might identify a price below which you are automatically going to sell the index. This will limit your losses if the price falls more than you expect.

Top Tip! Know Your Product!

As with any investment, it is a good idea to understand what you are doing before you start trading indices. This is an essential part of developing a trading strategy.

Take time to learn more about the indices that you are considering, and how they fluctuate daily, weekly and monthly.

It may also be an idea to get some professional advice on trading indices, to ensure that you are not exposed to more risk than you are comfortable about.

A Final Thought

Index trading offers a way to diversify your portfolio without having to trade individual shares. It is therefore a way into stock market trading that may be easier and low risk than trading stocks directly. However, it is not for everyone. Before you invest, it is wise to check that you are happy with the level of risk involved.

About the Author

Melissa has been writing content for SkillsYouNeed since 2013. She holds an MBA and previously worked as a civil servant. Now with a young family, she is learning all about applying her skills to real life.