There is always advantages, disadvantages and risk involved when participating in any form of trading, but involving indices in your strategy can diversify your risks, as well as your portfolio. There are several benefits that come with index trading, which we will explore further in this article.
What are indices?
Before understanding the potential that index trading can bring, let’s first explain what indices are. Indices are a collection of stocks and instruments, that track the growth or decline of an industry or sector. As well as speculating and investing in indices, it can also be used as a tool to understand more about the price fluctuations in the corresponding market.
The most popular index are the different major exchanges around the globe, including the Standard and Poor’s 500 (S&P 500) in the US and the Financial Times Stock Exchange 100 (FTSE 100), which are share indices for the top companies with the highest market capitalisation, listed on their corresponding exchange. Other commonly traded indices are the US Tech 100, which as the name suggests is the top performing technology companies in the US based on the NASDAQ 100, as well the most recent Crypto 10, following the performance of the top 10 cryptocurrencies.
How to trade indices
As aforementioned, there are a variety of indices you can trade, including country indices that follow the largest companies within an economy, or a sector index that is reflective of the top performing businesses in a particular industry.
The most common way to trade is through cash indices, future contracts or contracts for differences (CFDs). Cash indices, also know as spot, are more suited to those who partake in day trading, where as futures are based on a certain price to buy at a predetermined date, so are more suited for those with a long-term plan. CFDs allow investors to speculate on the price movement on the index, without owning any of the underlying assets, which allows you to take a position on both a rising or falling market.
The more you learn more about forex trading, stock trading and the commodities market, the more you can understand how they will affect the relevant indices. For example, the drop in value of a commodity can impact the share prices of companies involved with commodities. Whereas the fluctuations of a currency pair can be a reflection of the corresponding nation’s economy, which in part can influence the growth and health of the companies listed in that country’s relevant exchange.
The advantages of index trading
The main benefit of trading indices is that you can gain exposure to a specific market, whether that be globally, regionally or sector specific, without having to rely on analyse of the individual performance of a company’s stock. This can then be used in your portfolio to diversify trader risk, and potentially hedge the loses when trading in the assets in question.
For example, rather than investing in one particular stock from the tech sector, you can invest in the US Tech 100, which will give you natural diversification. If you then anticipate an announcement from one of these top tech companies, which will have a positive effect on the industry sector as a whole, you can potentially profit from trading in the tech-based index.
Likewise, the negative factors of these individual companies, especially those that are smaller in size, will not have as a great of an impact to the index as they would to the stock market. The influential factors on indices are also much less, in terms of quantity, than those on other markets.
Indices can also be used as a way to monitor the overall health and growth of a certain market, like stocks for example. This can be using a combination of current and historical data, to evaluate the likely market reaction to certain news and events, and can help investors to make well-informed decisions.