Indices Trading Strategies


When trading on an index, one is making trading decisions based on the combined value of a portfolio of stocks from a range of companies, rather than individual stocks from a single company. So, which areas can you study and focus on to try and maximize your chances of making a profit when trading indices? Here are some points to consider:

  • 01

    Research Relevant Market Sectors

    Before trading an index, examine that index’s component parts; is the index composed of shares from a range of industries, or do many of its shares belong to a particular market sector? The answers to these questions will give you a better understanding of the ways in which the value of an index may be influenced.

    For instance, companies listed on the FTSE 100 index are those with the highest market capitalization in the UK and represent approximately 80% of the wealth of the London Stock Exchange. For this reason, the FTSE 100 provides a good snapshot of market activity for UK companies. Additionally, over 10% of the shares listed on the FTSE 100 are mining and energy shares. Changes to the prices of commodities related to these sectors might lead to commodity-related stocks rising or falling, and so could significantly affect the value of the index.

    When deciding which index to trade, it is also worth considering the number of listings that make up an equity index – the number of companies listed on an index can range widely; some will only have a few tens of companies, whilst others can contain thousands.

  • 02

    Study the Relationship Between Currencies and Indices

    It is important to have an understanding of an index’s sensitivity to currency rates, as there is typically a correlation between the relative strength of a country’s currency and the value of its domestic indices.

    For example, the value of American indices generally increases with the demand for US Dollars. This may be partly due to foreign investment – as a growing number of traders invest in US stocks, they must first purchase USDs to buy American stocks, in turn causing US indices to increase in value.

  • 03

    Search for Correlations Between Commodities and a Country’s Domestic Index

    The relative value of certain currencies can be susceptible to change as commodity prices increase or decrese. An example of this is the price of oil. If oil prices decrease, say, because of weaker global demand, then Canada, an exporter of oil, would be at an economic disadvantage, whilst Japan, a major oil importer – would generally benefit.

    For this reason, it is advisable to study the movements of commodities that may affect the value of the index you are trading. Although correlations may fluctuate from day-to-day, over the long term, strong trends tend to occur, and searching and analysing these patterns could aid you in making better trading decisions.

  • 04

    Look Out for Changes to Index Listings

    The stocks listed on an index are subject to change over time due to factors such as market capitalisation and mergers and acquisitions. Here we describe these factors in a little more detail.

    Market capitalization:

    Many indices value a company in terms of market capitalization rather than sales or total asset figures. A company’s market capitalization is the total market value of its issued shares. This is calculated by multiplying the number of issued shares of a company with the current market price of one share.

    Because the total market capitalization of an index is affected by the individual share prices of the companies, as share prices fluctuate, an index’s value will change too. For example, as mentioned above, the FTSE 100 index represents an average of the share prices of the top 100 publicly traded companies on the London Stock Exchange. To ensure that the FTSE 100 reflects these top 100 companies, it is revised quarterly, in March, June, September and December. This makes the component stocks of an index subject to change over time.

    For example, if a company’s market capitalization plummets, its stocks may become too small to remain on the index that it is listed on. The company would then be demoted from that index, being replaced with a company with a higher market capitalization.

    Mergers:

    The stocks listed on an index can also change when mergers occur.  When two businesses combine to form a new company, the stocks representing each company combine to form one tradable entity. An example of this is the merger of the UK companies, Dixons and Carphone Warehouse in 2014. The two previously separate stocks merged into Dixons Carphone.

    For more information on trading indices, it is worthwhile reading our ‘What are Indices?’ and ‘How to Trade Indices’ pages. To start trading on indices, sign up for an account, or register for a demo account to start practicing today.

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