Index Trading: What You Should Know

Are stock indices benchmarks?

Stock indices are benchmarks that track the performances of selected groups of stocks. In the case of the popular S&P 500 index, which tracks 500 large-cap American companies, the purpose of the benchmark is to gauge the condition of the overall US economy. The index doesn’t give equal weighting to all its components, so, for example, Apple’s price movements will impact the S&P 500 more than other firms’. The Nasdaq 100 index skews its weighting in favor of tech stocks, so it’s used to gauge the performance of that particular sector of the economy. By contrast to these two indices, the Nikkei 225 index follows 225 key firms operating in Japan, thus functioning as a proxy for the Japanese economy.

Stock indices offer traders healthy diversification in a convenient package 

A single company’s earnings disappointment or failed product launch may cause its own share price to sharply drop, but not the price of the index as a whole. (The exception is when a highly weighted stock like Apple plummets, which could drag down the whole Nasdaq 100.) And not to forget, Indices are very liquid, so bid-ask spreads are tight!

Stock indices are less sensitive to news items than stocks are! 

While a stock’s price could fluctuate as much as 10% in response to a headline, this normally wouldn’t happen in indices trading which is characterized by greater stability and predictability in prices. Trading strategies based on macro sentiment and technical levels are more consistently reliable than in stock trading. 

Navigating price dynamics in indices trading is more straightforward than in stock trading. Therefore: 

You can expect index prices to shift in response to macroeconomic indicators on GDP trends, inflation, and interest rates. These be effectively anticipated by means of an economic calendar, thus said, technical analysis works well in index trading. In general, even when there is a major price driver in the news headlines, indices tend to move in a more orderly fashion than stocks 

What’s an example of an index trading strategy?  

Let us show you step by step:

- Consulting your economic calendar, you see the monthly NFP (nonfarm payroll) report is due this
morning at 8.30 a.m. ET  

- High NFP figures imply lots more jobs have been added to the economy, which would boost
consumer spending and, thus, inflation. This may cause the Fed to hike interest rates. 

- High interest rates are bearish for the Nasdaq 100 index because tech valuations are based on
future earnings expectations (which are now lower), and borrowing for development and ex
expansion becomes pricier. 

- NFP numbers come in hot, sparking a 200-point plunge in the Nasdaq 100 

- However, prices break through a key support level and trading volume dries up 

- Anticipating a price correction, you open a long position on the Nasdaq at 8.45 a.m. 

Later in the day, you see prices have corrected to their pre-NFP level. You close your deal and collect your earnings 

 *This is just an example and should not be considered a recommended strategy 

Frequently asked questions: 

Which indices are most commonly traded? 

Some of the most popular indices in trading are America’s S&P 500 and Nasdaq 100 indices, Germany’s DAX 40, the UK’s FTSE 100, and Hong Kong’s Hang Seng.  

How does index trading work? 

It works, not by actually purchasing stocks, but through speculating on the movements of an index within a set time period. You open a long position on the index when you believe its prices are due to surge, and a short position when you think they will drop. 

Can I trade indices through CFDs? 

Yes. Since you can’t trade the index itself, you need to choose a vehicle through which to gain exposure to it. Examples of these include ETFs and CFDs.