Indices trading: how to trade on indices

Indices are baskets of assets that show how different parts of the financial universe are performing. There are indices that track stocks, forex, bonds, and commodities. Each index is composed of assets and the index reflects the fluctuating values of the constituents within it.

Typically, when people refer to indices trading, they are talking about gaining exposure to global stock markets such as the FTSE 100, S&P 500 and Nasdaq 100. Some indices are categorised by the size of the companies they represent, such as the S&P Small Cap 600 and S&P Composite 1500. This helps provide investors with many trading opportunities. Businesses within an index must meet specific criteria. Companies within the S&P 500, for example, must have a certain market capitalisation.

Indices can provide a quick way to assess the health of a particular area of the economy and gain investment exposure to it. Stock indices, for example, can be quite specific, only holding assets from a certain stock market sector​​, industry or particular country. The movement of the index — up, down, or flat — shows how that area is performing, as a whole.

Indices are calculated and weighted in different ways. The company that manages the index determines how the index is calculated and the weighting of the stocks within the index. Here are some common methods used:

The value of an index depends upon many factors such as company productivity, prices, and employment. In order for a company to be added to an index, it could be selected by a committee, as is the case with the S&P 500. The committee will consider the eligibility of each new addition based on strict criteria, such as market capitalisation, financial viability, and length of time it has been publicly traded on the stock exchange. Otherwise, there will be rule-based entry, as exists with the Russell 1000 index, which consists of small companies.

As an indicator or benchmark of the top-performing businesses in a particular industry, the value of an index is affected by the performance of its constituent companies. Benchmarking can be used to measure a fund or stock’s performance. Market indices will typically be used as a benchmark, as they can give a broad market view for comparison. Indices can help to track a market’s changes over time. An investor might use the FTSE 100 as a benchmark to assess their own portfolio’s performance, for instance.

Indices can be a low-cost way to trade on a basket of stocks. Indices can have large daily price moves, since they have multiple assets contributing to their value and are influenced by several macroeconomic factors, which we will discuss in more detail below.

One benefit of trading indices is that they might pose a lower risk than individual stocks. As the risk is spread out across a number of assets, an index is unlikely to go to zero or go bankrupt, like an individual stock could.

Indices are often useful for longer-term investors that aim to diversify their portfolio​​, since a wide range of stocks or other assets can be purchased with a single transaction. They are also popular for day trading, since indices are often discussed regularly in the news and have price movements throughout the day that day traders attempt to capitalise on.

When an index is rising, it is said to be in a bull market​​. During such times, opening a long (buy) position on the index allows traders to potentially profit from the rise without having to buy, trade or research individual stocks. Similarly, when an index falls 20% or more, it’s said to be in a bear market​ and traders can potentially attempt to profit by shorting in a downward trending market.

Here’s a list of the most traded global stock indices and their main constituents:

Comparing indexes can be a useful exercise when deciding which sector you would like to invest in or trade. For example, The S&P 500 index is typically known for having lower volatility than the Dow Jones Industrial Average. So, for a long-term investor, the S&P 500 may be deemed more favourable.

The opposite is true for day traders who actively seek out market volatility in order to make potentially larger returns in shorter timeframes.

Indices can be compared by viewing price charts over equal timeframes, and the more data you have, the more accurate the comparison will be, as prices can change dramatically over a single day. For example, reviewing an index’s indices price over a period of one year will give you a more accurate impression of that market’s overall performance.

Volatility refers to how fast prices change and is a way of gauging current market sentiment. The volatility index​​​ was created in order to assess the S&P 500 market but is often used by investors and traders to study the volatility of the US market as a whole. The VIX volatility index represents the market’s expectations of price changes within the S&P 500 over the next 30 days.

A very high volatility often represents fear amongst investors, which is why the VIX volatility index is commonly known as the "fear index" or "fear gauge". When there is fear within the market, the VIX percentage value tends to increase in times of high volatility and decrease when the market stabilises.

Indices with a lower volatility, such as the S&P 500 Low Volatility Index, can be negatively affected by rising interest rates. This is due to the characteristics of sectors usually linked to these strategies, such as utilities and staples.

There are a wide range of factors that affect global stock indices. Here are some of the major factors:

There is no definite best day or time to trade on indices, but certain points in the day tend to have larger and more frequent price movements than others. For example, the market opening and the last hour before closure tend to show the greatest volatility. It is also stated that typically, both Mondays and Fridays see more volatility than Wednesdays.

However, greater volatility should be treated with caution. This is because as much as it is possible to attain larger profits, the potential to make larger losses also poses a threat, so this should be considered within your risk-management strategies.

This is where traders look at the health of the stocks in the underlying index, which are called market internals. Market internals include market breadth indicators such as:

News events such as the release of fresh economic data, which are scheduled in advance in an economic calendar, can cause volatile price movements in a stock index. For example, one of the economic indicators most likely to move the market is non-farm payrolls​​, which is a measure of employment in the US (one of the Federal Reserve’s main mandates) and is released on the last Friday of every month.

One of the biggest market-moving news events is central bank interest rate announcements. These announcements often cause quick price moves, with follow-through movement that can last for days as traders digest and trade the news​​.

Market sentiment is how willing people are to buy or sell. When sentiment is increasing, this is typically a good time to own stock indices, since more people are buying stocks. This is called “risk on” because people are willing to take on risk and buy. As bullish sentiment declines, or bearish sentiment increases, stock indices are more likely to decline. This is called “risk off” because people are selling assets to remove the risk of the position.

Market positionings shows the extent to which traders are long or short on an index or financial product. When positioning reaches an extreme, which will vary by each index, that may indicate a potential reversal in the price of the index. As an example, if 99% of index positions are long, that shows there are very few people who have shorted or think the market could correct lower. Such a scenario often ends with a price drop.

When trading on indices with our Next Generation platform, we use a client sentiment indicator that shows the percentage of clients that are long and the value of those trades, which can be used to inform your view on market positioning and take trades according to your strategy.

Stocks and stock indices are affected, and can have an effect, on other assets. For example, a rising VIX index tends to correlate with falling stock indices. Rising bond prices tend to be good for stocks as it shows interest rates are getting lower, while falling bond prices means lack of demand to own bonds, higher interest rates, and downward pressure on stock indices.

Technical analysis uses statistics, technical indicators, and the price history of the stock index itself to help determine the future direction of the index. Popular technical indicators include the MACD, RSI, and Bollinger Bands. Traders can also use support and resistance, which are price levels that may form a temporary top or bottom in the trajectory of the index. They also utilize candlestick chart patterns to try and predict where the market will go. These tools are used to create technical analysis strategies​.

Indices may form trends intraday or over the longer-term. Trend trading​​ involves buying as prices are rising, assuming the trader believes prices will continue rising. If the price is falling, in a downtrend, a trader may short if their analysis determines that prices may continue falling. Since indices move to different degrees, some traders may opt to use leverage trading to magnify the price movements of the index.

Indices can gap higher or lower over the weekend, as there is no trading between Friday and Sunday (or Monday in some cases). A gap occurs when the opening price on Sunday is different than the closing price on Friday. In the event of a gap, some traders use a gap trading strategy​​ where they watch for the price to move back toward the Friday close.

Trading on indices via a mutual fund is another popular way to invest. A portfolio is set up to match the performance of a particular index. Mutual fund managers provide index funds that track the FTSE 100, for example, which often offer broad market exposure.

If on average the share price of the index’s constituents goes up, the value of the index should rise along with them. If these companies’ share prices fall, the value of an index should drop. Since indices are made up of many stocks, their value tends to fluctuate. Some indices are more volatile than individual shares. This has the benefit of numerous trading opportunities but can also add risk for the trader.

With CMC Markets, you don’t trade on or invest directly in the global index. Instead, through spread bets and CFDs, you can speculate on the price movements of derivative instruments that are based on the FTSE-100 and more. Traders can take a position based on whether they think its value will rise or fall, and subsequently make a profit or loss depending on which way the markets move.

Here’s a breakdown of how this can be done on our Next Generation platform:

Assume a trader believes that UK stocks will fall, and they want to potentially profit from the decline by trading on our UK 100 – Cash​ instrument. Using a spread betting account, they open a position on our derivative instrument.

They determine how much they wish to risk per point of movement in the index. Assume they go short at 7,069, and they are willing to risk £1 per point. Assume they believe that if the price falls, it will fall to 6,800. This is where they place the profit target, 269 points below the entry. If the price falls and reaches the target price, the trade is closed for a £269 profit.

They place a stop loss at 7,100, which is 31 points above their entry price. This means that they are risking £31 on the trade. If the price moves up to 7,100, they could exit the trade at a loss.

We offer both cash and forward assets on our Next Generation trading platform. Whereas index forward contracts​​ have an expiry date, a cash index does not, but you can automatically roll your position over into the next contract on expiry. With a cash index, you pay an overnight holding cost but with forward trading, you do not. This makes forwards cheaper to trade than cash indices if you are holding over a longer period. Cash prices and forward prices will often be slightly different since a forward doesn’t mature/expire until sometime in the future.

Type an index name into the platform’s search bar and you can find the option to trade a cash index and/or forward indices. Forwards have a future date next to the index name.

Trading hours vary by the index. For exact trading hours on each index, right click on any index name in the product library and select ‘Product Overview’.

For example, our trading hours, in London time, for the US SPX 500 forwards are from 07:00 to 22:00, and then again from 23:00 to 07:00. There is no trading between 22:00 and 23:00. Trading ends at 22:00 on Friday and resumes at 23:00 on Sunday.

Trading hours on the UK 100 (London time) are the same as the SPX 500, except that trading begins at 23:05 (instead of 23:00) on Sunday.

Indices trading is considered by many to be a lower-risk strategy, as you are spreading your risk across an entire segment or sector, as opposed to a single stock. However, there are still some risks involved.

You are trading a derivative instead of a physical asset. Here, a derivative is an instrument that obtains its value from the price of an underlying asset, such as an individual stock or stock index. The risk is that the movement of just one stock or security within the index could have a major impact on the value of the index.

It’s therefore important to do some research prior to trading indices. It’s a good idea to make use of risk-management tools​​ to protect your positions against sudden market moves. These include stop-loss orders such as guaranteed stop-losses. A stop-loss order will close a losing trade once price passes a trigger value pre-decided by the investor. These are very effective in the event of sharp price action.