Looking at gaining exposure to global indices? Read here.
In a previous article, we discussed what indices are and how they can be a part of your investment portfolio. Here, we delve deeper into the topic with some tips when trading indices.
When gaining exposure to indices, investors make decisions based on the combined value of a portfolio of stocks from a range of companies, rather than individual stocks from a single company. For successful, profitable trading, you should research the following focus-areas to maximise your trading results:
- Examine the index’s component parts and relevant market sectors to understand the ways in which the value of the index may be influenced.
- Study the index’s sensitivity to currency rates as the value of a country’s indices may be correlated to the relative strength of its currency.
- The relative value of certain indices may correlate to the changes in commodity prices. Therefore, you should be aware of the changes and trends in commodity prices that may affect the value of the index you are trading.
- Be aware of changes in index listings due to factors such as market capitalisation, mergers and acquisitions.
Here are some of the common ways investors can get exposure to indices and some of their most popular trading techniques.
Ways that share CFDs can differentiate your trading strategy.
This is a popular way of trading indices. Most major stock indices have corresponding futures contracts that are traded on a futures exchange. As with all other futures, index futures are traded by taking a long position or a short position.
A long position is desirable when you expect the index price to increase before the expiry date of the future and thus you can profit by selling for a higher price than you paid for the future.
A short position would be taken if you expect a fall in the index price before the expiry date. Therefore, if you sell the future at a fixed price now, you could profit by buying it at a lower price at expiry date.
Index futures trade on leverage like any other futures – you have to put down a margin of the total value of the contract and this gives you magnified exposure to the market.
You could benefit by trading index futures as it allows short-term trading in a volatile market. It can also be used to hedge your exposure in a stock market or sector for a small amount of up-front capital.
The limitations of this trading technique include the lack of customization (which means that the size of the contracts might not exactly match your needs) and margin rates (which may imply substantial amounts as margin payments).
The holder of an index option has the right to buy or sell an index at a predetermined price and date. Profits are generated from expected moves in the market or by mitigating the risk of holding the underlying instrument in particular indexed funds.
Options traders choose between a call or put strategy.
With a call option, a basket of stocks are bought at a predetermined price with the expectation that the value of the index will rise. This is a bullish strategy as the value of the call option increases as the value of the underlying index rises.
A put option is the right to sell an index at a predetermined strike price. The value of the put increases as the value of the underlying asset decreases and is, therefore, a bearish strategy.
Benefits of using options include obtaining exposure to an entire market or industry with a single transaction and smaller amounts of capital and that the financial risks for call and put options are limited to the total premium paid for the option. The use of index options can generate steady income for long-term investors and provide stability and peace of mind for less risky investors.
It may be seen as a limitation that the profit potential is limited to the underlying index increasing or decreasing to the strike price.
More advanced options strategies include index straddle and index collars.
Exchange Traded Funds (ETF)
ETFs are marketable securities that track indexes or a basket of assets like an index fund. ETFs trade like stocks on a stock exchange and experience price changes throughout the day as they are bought and sold. The ETF holder is entitled to a proportion of the profits, such as earned interest or dividends paid and they may get a residual value in case the fund is liquidated.
Popular ETF Trading strategies like dollar-cost averaging, asset allocation, swing trading, sector rotation, short selling, betting on seasonal trends and hedging have many features that make them ideal instruments for beginner traders and investors.
The advantages include diversification, high liquidity, relatively low fees and easy trading since ETF shares are traded on public stock exchanges.
Contracts for Differences (CFDs)
An Index CFD is priced to track (either fully or partially) the movement of the underlying index. The underlying assets are never owned and it is basically a contract between the client and the broker. The difference between where a trade is entered and exited is what is meant by the Contract for Difference (CFD).
Advantages of Index CFD Trading include higher leverage, global market access from one platform, ability to take short positions, out of hours trading and lower transaction cost.
Potential limitations of Index CFDs include the obligation to pay overnight funding costs to hold a leverage position. The industry in certain countries is not highly regulated and investors have to be careful to select a broker that fulfils your trading needs.
A reputable CFD provider is essential when trading using leverage, so it pays to choose yours wisely. IG has over 40 years of industry experience and is part of IG Group Holdings Plc, which is listed on the London Stock Exchange. Besides providing access to numerous global markets, IG also offers opportunities for lower margin requirements while reducing the downside risk exposure, and provides investors with expert analysis and a 24 hour helpdesk.
Traders: Here’s the benchmark for CFD trading.
This article was sponsored by IG, the world’s No.1 CFD provider (by revenue excluding FX, 2016). All views expressed in the article are the independent opinion of ZUU.