Over the last two decades, index trading has exploded in popularity and become the most common way individuals invest in the markets. Many investors today use only index funds to grow their accounts. And that is for good reasons: index funds have become low-cost and simple to use. Index funds are also easy to access, with banks, financial advisors, and brokers offering index investing. Read on to find out more about index trading.
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In this article, I will cover:
- What is an index.
- Different types of indices trading.
- Some index trading strategies.
What is an Index?
An index is a measure or scale of something.
Indexes in the financial markets are usually an average price of a collection of related securities.
Imagine collecting the prices of a bunch of stocks and making it an average. Now you have a stock market index. If the collective average price of the stocks rises, then the value of that stock market index will also rise.
Nearly all securities have an index to measure their value. Let’s look at some of the key ones.
S&P 500
The S&P 500 is the most popular index in the world. When people think of index trading, they often think of this index.
The S&P 500 is a combined value of a sample of the 500 top US companies. The S&P 500 index was officially established in 1957 by the US company, Standard & Poor’s, or S&P for short. The history of the S&P 500 index goes back a little further to 1923 when Standard & Poor’s established an index containing 233 companies.
The S&P 500 is widely regarded as the best single gauge of the U.S. stock market. It covers approximately 80% of the U.S. equity market capitalization and about 30-50% of the global equity market.
Dow Jones Industrial Average (DJIA)
The Dow Jones Industrial Average (sometimes just called the Dow Jones or simply the Dow) is a stock market index of 30 prominent companies listed on stock exchanges in the United States. Founded in 1885, the DJIA is one of the oldest and most followed equity indexes.
Nasdaq-100
The Nasdaq-100 is a stock market index of 101 stocks issued by 100 of the largest non-financial companies on the Nasdaq stock exchange. The Nasdaq-100 is very technology focussed, with tech stocks currently making up more than half of the Nasdaq-100 value.
Russel 2000
The Russell 2000 Index is a U.S. stock market index specializing in small companies and, as the name suggests, contains 2000 stocks. The Frank Russell Company started Russel 2000 in 1984.
Dollar Index
The U.S. Dollar Index is an index of the value of the United States Dollar relative to a basket of six currencies: Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Dollar, and Swiss Franc. The six currencies are often called the U.S. trade partners’ currencies. The Index increases when the U.S. dollar gains strength compared to other currencies.
Non-U.S. Stock Market Indexes
UK: The FTSE 100 contains 100 stocks on the London Stock Exchange.
Canada: The S&P/TSX Composite Index contains approx. 250 companies on the Toronto Stock Exchange.
Japan: The Nikkei 225 contains 225 stocks on the Tokyo Stock Exchange.
Germany: The DAX contains 40 stocks on the Frankfurt Stock Exchange.
India: The BSE SENSEX contains 30 stocks on the BSE (formerly Bombay Stock Exchange).
MSCI World Index: This index captures over 1500 stocks from 23 developed countries: 16 European countries, 5 Pacific nations, the US and Canada. US stocks make up over half the value of this index.
Other index categories
There are many other index types, some specializing in narrower categories:
- Sector indexes: For example, the S&P produces indexes on stocks in materials, energy, financials, real estate, and many others.
- Value stocks
- Growth stocks
- Fixed Income or bond indexes
- Cryptocurrency indexes
The list goes on—there is an index for any market category you can imagine!
What is Index Trading?
Index trading is a type of trading strategy in which you trade baskets of stocks or other assets that represent a particular market or sector. The baskets comprised of the members of an index. For example, if you are trading the NASDAQ 100, you are trading a basket of 100 technology shares. An index is often weighted according to the market values of the components. For example, the S&P 500 is weighted by market capitalization, so the biggest companies which are members of this index have much influence over the price of the index than the smaller ones.
The great thing about index trading is that it can give you exposure to a diversified portfolio without having to buy each asset individually. Index trades may be executed by using index funds, exchange-traded funds (ETFs), futures contracts, or options. The true goal in index trading is to capture the overall performance of the market or sector, instead of trying to pick individual winners and losers. So, index trading is usually a more passive approach to the market.
How are Stock Market Indices Calculated?
Most stock market indexes are calculated in similar ways, but we will focus on the S&P 500 as the world’s leading stock-market index.
Step 1: Eligibility criteria.
Standard & Poor’s is unique in having an index committee with discretion in selecting stocks or responding to market events. According to Standard & Poor’s, “The Index Committee’s mission in maintaining the S&P 500 is to represent the US equity market with a focus on the large-cap segment. The Committee is not trying to pick stocks to beat the market. Rather, we use guidelines for stock selection—size, liquidity, minimum float, profitability, and balance with respect to the market—to assure that the index is an accurate picture of the stock market.”
Step 2: Weighting.
Weighting is a critical concept in index calculations. Typically, if I calculate an average of different numbers, such as stock prices, I take all the prices and divide them by the number of stocks. Let’s say I have five stocks, A, B, C, D, and E, and their prices are $5, $14, $3, $8, and $6. Their average price is (5+14+3+8+6) divided by 5, which equals 7.20. Now let’s say Stock A goes from $5 to $9, and Stock B has fallen from $14 to $7. My average is now (9+7+3+8+6), which equals 6.60. I could say that my index of 5 has fallen from 7.20 to 6.60.
However, now let’s say Company A is twice as big as Company B. Should that not matter? Should Stock A have a higher effect on the average than Stock B? Yes, it should. To account for the varied sizes of companies, the S&P 500 is a “free-float weighted average.”
What is a free-float weighted average? This method calculates the market capitalization of each company in the index. The calculation multiplies the stock’s price by the number of shares readily available in the market.
Instead of using all the shares (both active and inactive shares), as is the case with a full-market capitalization method, the free-float method excludes locked-in shares, for example, those held by company insiders and governments.
Weighting an index means that larger companies will have a larger effect on the value of the index as their stock prices change.
How to Trade Indices
Rather than buying each company or security in the index, investors can buy a single security that tracks the value of the index:
- Futures. For example, the “S&P 500 futures” contract trades on the Chicago Mercantile Exchange.
- ETFs or Exchange Traded Funds. These trade like individual stocks but track the value of an index.
- CFDs (Contracts for Differences). Like ETFs, CFDs trade like individual stocks but track the value of an index. Not all countries allow trading in CFDs.
- Options. Index options work similarly to stock options, with calls and puts, strike prices and expiration dates.
What Moves Index Market Prices?
- Macroeconomic factors. Inflation, employment, and interest rates all affect the broader economy and can affect all indexes, from stock market indexes to precious metal indexes and bond indexes.
- Individual constituents in an index can move its value. In a weighted index, larger constituents, such as Apple in the S&P 500, will have a larger effect on the index’s value, compared to smaller companies like American Airlines.
- Certain categories of an index, such as economic sectors, can perform well or poorly, affecting the index. For example, if retail stocks face trouble because people spend less in stores, the entire sector can perform poorly in the index, significantly affecting the total index value.
Benefits of Index Trading
- Instant diversification. For example, if I trade an individual company’s stock, and unexpected earnings or news events affect the company, it can significantly affect the value of my holdings. Remember, individual companies can go to zero. It is highly unlikely that will happen to the whole index. So, if I am trading the S&P 500 index, it will smooth out the ripples compared to trading individual stocks. This is called “diversification” and reducing “systematic risk.”
- Less gapping. When the price of a security gaps, it trades at a different price level without covering intervening prices. If a stock closes at $100 but opens the next day at $80, it has had a $20 gap. If I had a stop-loss at $90, the market would fill me at $80, increasing the size of my loss. With entire indexes, gapping is less likely because of the diversification within the index.
- Better technical analysis. The larger the pool of liquidity, the higher the quality of technical analysis I can perform. That is because technical analysis relies on an element of crowd psychology.
- More people do index trading, so more resources and expertise exist. This helps quicken the learning curve.
What ways can you trade stock market indices?
Step 1: Decide on the instrument. Most indexes can be traded as Futures contracts, ETFs or CFDs. Decide what kind of an instrument you prefer. Factors such as margin requirements, leverage and broker choice will affect the decision.
Step 2: Decide which indexes. There are multiple stock market indexes. In the US, there are dozens of stock market indexes, the leading being the S&P 500, then the Dow Jones Industrial Average, Nasdaq 100, and Russel 2000. Then there are sector indexes, e.g., the S&P Technology Index. Internationally, each country with a stock market will have at least one index. For example, the first index I traded was the UK’s FTSE 100 using futures contracts.
Step 3: Get to know the indexes you want to trade. Each will have its fundamentals, macroeconomic events, and even technical properties. For example, the S&P 500 can trend very well and makes clear support & resistance levels. Know which news announcements will move each index. And then construct a strategy or learn one from someone else.
Index Trading Strategies
Classic Technical Analysis
Indexes are great for technical analysis strategies because they have large crowds of people following them and high liquidity. On a chart of any index, I can draw:
For example, I have traded the trends on the S&P 500 and support and resistance role reversals on the FTSE 100.
Passive investing: Buy & hold equity indexes.
This is a popular long-term investing strategy. Many equity indexes have decades-long records of bullishness. Sure, there are dips, such as how the 2008 financial crisis affected most stock markets. But suppose I am investing for a very long-term horizon, such as a decade or more, for example, for retirement. In that case, regularly buying positions in major equity indexes is a good strategy. It is common to see individuals with retirement plans buy S&P 500 ETFs every month. The average annualized return from 1957 to 2021 of the S&P 500 is 11.88%—an excellent long-term return on savings and better than most interest rates had I held my savings as cash. This is known as “passive investing.”
Golden Cross strategy on the S&P 500.
The “golden cross” strategy has become a popular way of actively trading the S&P 500. It involves buying when the 50-day moving average crosses above the 200-day moving average and selling when the 50-day moving average crosses the 200-day moving average from above to below.
Bottom Line
Index trading is an efficient way to access key markets without buying individual securities, such as shares. It allows for instant diversification, which helps contain systematic risk.
Index funds are available from banks, financial advisors, and brokerage accounts. I can trade index funds using Futures, ETFs or CFDs.
I can use classic technical analysis on any index, such as support and resistance levels and trends. I can also buy and hold indexes that I believe will continue going up long-term, e.g., the S&P 500.
FAQs
Is trading index profitable?
Yes, all trading carries risk, but index trading can be as profitable as any other trading.
When is the best time for index trading?
Indexes move through economic cycles. When there’s volatility, that is often a good time to trade indexes because there’s price movement to capture.
How does index trading work?
You can trade indexes with futures, options, ETFs, or CFDs.
Is index trading risky?
Index trading is usually less risky than individual securities, such as stocks, because indexes are better diversified. Of course, there is some risk in all trading.
Which is the easiest index to trade?
The S&P 500 is the most popular index to trade.