Trading Indices: A brief guide to index trading by Octa

Index trading is a great way to engage with the stock market, whether you are just starting or have years of experience. It involves buying and selling financial instruments linked to stock market indices and allows you to benefit from the performance of a whole market segment or even the entire market.

Analysts from Octa, a broker with globally recognised licences, present this guide to index trading, an appealing option to diversify your trading strategies.

What are indices?

Indices are straightforward measures of how asset groups perform in the market. They depict specific sectors, markets, or entire economies. And they are not limited to just stocks, which is the first thing that usually comes to mind when mentioning stocks. They can include bonds, commodities, and more.

There is an index representing every major financial market worldwide. Take the S&P 500, for example. It tells us how the 500 largest publicly traded U.S. companies are doing, and it is a quick way to gauge the pulse of American finance.

Important: While retail traders can buy all the assets in an index, it requires large budgets. That is why index-linked products like ETFs and index mutual funds are popular—they offer an easier way for people to engage with an index's overall performance without investing much money.

Major world indices

Some of the biggest and most widely traded indices in the following regions are:

● USA: S&P 500 (around 500 large-cap U.S. companies), Dow Jones (30 large, publicly traded U.S. companies), NASDAQ (more than 2,500 stocks, predominantly technology and biotech companies), Russell 2000 (approximately 2,000 small-cap U.S. stocks)

● Europe: FTSE 100 (100 largest companies listed on the London Stock Exchange), DAX 30 (30 largest companies on the Frankfurt Stock Exchange), CAC 40 (40 largest companies on the Euronext Paris exchange), BEL 20 (20 largest companies on the Brussels Stock Exchange)

● Asia: Nikkei 225 (Tokyo Stock Exchange's top 225 companies), Nifty 50 (50 of the largest Indian companies).

The most popular indices are based on stocks, but there are other types. For example, commodity indices track commodities like crude oil, gold, and coffee. The S&P GSCI Crude Oil Index follows crude oil prices, and the United States Oil Fund tracks daily changes in WTI crude oil prices. Currency indices show how currencies compare to each other. For example, the U.S. Dollar Index measures the dollar's value against other currencies.

Finally, sentiment indices gauge how traders feel about the market. The CBOE Volatility Index attempts to quantify sentiment and shows volatility in S&P 500 option contracts. A higher VIX means more market ups and downs and possibly more fear, while a lower VIX means things are steadier.

How are indices calculated?

Indices are calculated in three main ways:

● price-weighted. Assets are weighted based on their share prices. This means companies with higher share prices have a greater impact on the index's value. Examples: Dow Jones Industrial Average, Nikkei 225

● market-capitalization-weighted. Companies are ranked based on their market capitalisation, multiplying their stock price by the number of outstanding shares. Companies with the largest market capitalisation exert the most influence. Examples: FTSE 100, DAX 40

● equal-weighted. Each constituent company is given the same weight. This evens out the influence of individual stocks on the index's performance and reduces volatility—for example, the S&P 500 Equal Weight Index.

Who determines how an index is calculated?

When it comes to ETF funds, the answer is the provider, a specialised company that focuses on developing and computing market indices. After selecting and weighing the index constituents, the provider starts calculating the index based on the agreed-upon methodology. This calculation typically occurs daily, with many indices computed in real time. Providers also keep indices up-to-date and balanced and grant licences to use the index's name and replicate its performance to qualified firms.

The exchange determines the calculation method for indices in general. For example, Nasdaq Inc. determines the Nasdaq Composite.

Pros and cons of trading indices: what beginners should know

Advantages of index markets:

● diversification. Trading indices lets you invest in a wide range of assets, diversifying your risk. This way, if one asset performs poorly, it will not heavily impact your entire portfolio

● lower costs. It is usually cheaper to trade indices than individual assets

● simplicity. Index trading is straightforward and accessible for both beginners and experienced investors

● flexibility. Many indices are available, catering to different risk levels and goals. You can choose indices based on specific sectors, market sizes, or regions.

Disadvantages of index markets:

● limited upside potential. Most popular indices are considered conservative in terms of profit potential. You might miss out on the exceptional performance of individual assets or sectors. Although, there are exceptions, especially in the emerging technologies sector (e.g., the AI Index)

● crisis impact. The presence of industries experiencing crises within an index can negatively impact its overall profitability.

Most other things about indices are pretty universal for other trading instruments. For example, always use stop-loss orders to protect your trades and avoid the temptation to trade too frequently. It also helps to learn the basics of technical analysis (charts, trends) and fundamental analysis (financial health of companies in the index, economic indicators).

Popular index trading strategies

There are several popular index trading strategies

1. Trend trading

Anticipate the market's direction and capitalise on upward or downward spikes or changes. The goal is to enter a trend early and close the position near the peak. You can use such technical indicators as RSI, MACD, and Bollinger Bands.

2. Trading retracements

Traders using this strategy wait for temporary price movements against the main trend. They buy during corrections in an uptrend or sell during corrections in a downtrend to enter the market at more advantageous prices.

3. Trading reversals

Identify fundamental shifts in the market direction. Sell in a downtrend when the price forms lower highs and lower lows, or buy in an uptrend when it forms higher highs and higher lows.

4. Trading breakouts

Identify patterns and cycles in market volumes, volatility, and direction. Enter trends early when prices break through support or resistance levels. Consider using limit-entry orders for automated trades.

5. CFDs trading

Trading index CFDs lets you profit from market changes in both directions. For instance, assuming an index will go up, you can take a long position. You can take a short position if you expect an index to drop.

In contrast, when you directly buy an index fund, you only profit if the value goes up. But with CFDs, you can profit whether the index rises or falls.

Conclusion

Trading indices provide portfolio diversity without the hassle of managing multiple individual positions. Learning to trade CFD indices is invaluable, even for traders primarily focused on other assets. You can trade indices on the stock exchange or use CFDs through global brokers like Octa. The top popular indices to trade are the FTSE 100, Dow Jones, S&P 500, and DAX 30, among others.

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Source: Legit.ng