Were you aware that the entire online investing marketplace is thought to be worth more than 8.2 billion dollars(1)? It is also estimated that no fewer than 58 percent of all Americans own at least one stock (2). These figures should not come as a great surprise when we consider the sheer number of opportunities that the digital trading community has to offer. When we then remember that the use of online platforms can lessen the impacts of commissions that are often associated with traditional brokers, the advantages become clear.
If you are interested to learn about how to generate a side hustle and you wish to keep one step ahead of the curve, one worthwhile approach to consider involves a method known as index-based trading. What does this strategy involve? Are there any unique benefits to appreciate? These are two of the many questions which we will address throughout the remainder of this article.
What is a Stock Market Index?
A market index is essentially a collection of assets associated with a certain economic sector. Some common examples include:
- Blue-chip stocks
We can think of an index as a benchmark that is used to indicate the health of the sector in question. Indices will also be analyzed to better understand how the values of specific assets fluctuate in relation to one another. In fact, the chances are high that you are already familiar with the more well-known indices such as the Dow Jones Industrial Average (DJIA), the FTSE 100, and the S&P 500.
A Clear Definition of Index-Based Trading
It is now important to address another relevant topic. Let’s take a look at how to trade on indices on indices as well as some of the benefits attributed to this approach.
One popular option involves what are known as contracts for difference (CFDs). An investor will first predict whether the value of an index is expected to rise or fall. In the event that a re-correction is imminent, a sell (short) position will be opened. If the index is expected to gain value, it is better to enact a buy (long) position. The main takeaway point here is that the trader will turn a profit as long as the predicted movement occurs within a specified time frame. So, it is possible to make money even if an index enters into bearish territory.
Another CFD-related strategy is referred to as a futures index trade. In this case, an investor will examine the long-term outlook associated with a certain index. These futures are then traded at an agreed-upon price at a later date (assuming that the prediction is correct). Note that this is often preferred by those who are interested in medium- to long-term prospects.
Short-term investors could instead opt for cash indices. They will trade a CFD at the current market price (known as the spot price). Due to the relatively brief nature of these positions, the spreads tend to be tighter. While they are inherently more liquid, the levels of associated risk tend to rise.
What Other Strategies Can be Employed?
The previous section was intended to provide nothing more than a brief overview of the main approaches that traders will take when becoming involved with a market index. There are nonetheless a handful of additional methods that can be used in order to mitigate risk and to increase the chances of turning a profit. Without further ado, let’s begin.
Examining The Stocks Contained Within the Index
This is often referred to as “internal trading”. Similar to examining the fundamentals of a company before purchasing shares, internal trading is centered around the movements of the stocks within the index itself. Some metrics that can be analyzed include:
- Rising versus falling shares.
- Overall trends in value.
- Short- and long-term moving averages.
- Index volatility
Those who are able to obtain a clear overview of these factors will be in a better position to make an informed decision.
Day trading is arguably the most popular form of index investment due to the potential to turn a short-term profit. The intention here is to take advantage of sudden price shifts at the appropriate times. However, day trading requires a fair amount of skill, and keeping abreast of late-breaking news may pose a challenge for some who are already dealing with hectic schedules.
This method intends to capitalize upon the beginning of a trend (such as when an index is set to hit a predetermined support level; encouraging investors to buy). Those who are able to become involved at an early stage are more likely to accrue appreciable profits. When managed with proactive oversight, this approach can also help to limit downside risks.
Chart-Based (Technical) Trading
Others might instead prefer a more quantitative (technical) approach when trading indices. They can employ various utilities such as candlestick charts, momentum indicators, index volume measurements, and volatility rates in order to better understand the right time to open a position. Once again, learning the ins and outs of technical trading requires a fair amount of time and effort. The good news is that CMC Markets is always here to help.
What are the Benefits and risks of Trading Indices?
One notable advantage of this type of trading is attributed to the fact that indices tend to be more buoyant in terms of massive price swings. For instance, an individual share could experience a great deal of volatility within a short period of time. Even if the index is set to experience an uptick or a re-correction, it is normally possible to interpret such signals ahead of time. Nevertheless, the risks associated with any trading activity remain the same. Traders can lose significant amounts of money from one day to another.
Another powerful windfall here is that an index will not become illiquid or bankrupt. This is certainly not the case when we recall the financial crisis of 2008 and the downfall of firms such as Lehman Brothers and Swiber. Therefore, traders will not have to worry about their holdings simply “evaporating” overnight. However, it is still important to keep track of price movements in order to remain one step ahead of the curve and mitigate high risk by employing stop-loss orders.
On the other hand, indexes likewise represent excellent long-term trading strategies. This is due in large part to their relatively stable nature. So, this type of investment strategy can represent an excellent way to balance a portfolio against short-term positions.
On a final note, the cost of index trading is considerably lower when compared to other approaches such as stocks or equity futures. This is a crucial concern if you happen to be hampered by a limited budget or you simply wish to explore the different options without committing a great deal of capital at any given time. Bear in mind that you are still at risk to lose the money that you have funded your trading account with.
Could Index-Based Trading be the Right Move for You?
While there is no such thing as a risk-free investment, trading on indices like US 30-cash is one of the most effective ways to minimize its effects. This method could also represent a great approach for beginners who are hoping to better appreciate how market fundamentals will impact the price of a certain group of assets. In fact, some novices choose to begin their careers with index-based trading before moving on to niche sectors such as individual shares or commodities.
The best way to fully appreciate the options at your disposal is to open up an account with CMC Markets. You will be provided access to a host of unique tools and there are also plenty of trading guides to read at your convenience. When we consider how volatile the prices of individual holdings can become on occasion, the power of index-based positions becomes clear.
*Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The vast majority of retail client accounts lose money when spread betting and/or trading CFDs. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.
*Marketing for CFDs and spread betting is not intended for US citizens as prohibited under US regulation.