Trading Stock Indexes

Stock indexes are a measure of the performance of the biggest companies in a stock exchange. A stock index is also known as a stock market index. There are several types of stock market indexes. Understanding the function that a stock market index serves will help the trader understand how to trade the stock index.

Types of Stock Indexes

This classification is not a standard classification, but is an attempt to help the trader to understand how these indexes function so as to understand how to trade them. Based on this therefore, indexes can be classified in the following ways:

a)    Global Index: This is an index that measures the performance of several big corporations all over the world, irrespective of what countries these companies are domiciled. Examples of such exchanges are the MSCI World (formerly Morgan Stanley Capital International), which is an index that measures the performance of more than 6,000 stocks scattered all over the globe.

b)    National Index: this is the index that measures the performance of companies located in a particular country. The national index measures the performance of a country’s stock market and by extrapolation, a country’s economy. Examples of some of the common national indexes are the Nikkei 225 (Japan), Hang Seng (Hong Kong), FTSE100 (UK), CAC40 (France), Zurich SMI (Switzerland), IBEX35 (Spain), SENSEX (India) and Tadwul (Saudi Arabia).

c)     Specialized Index: Specialized indexes measure specific sectors of the market within a country’s exchange. An example is the Morgan Stanley Biotech Index which measures the performance of 36 Biotechnology stocks within the United States. Another example is the Wilshire REIT which is an index that measures the performance of the stocks of 80 real estate companies in the US.

For the purposes of this article, we will be discussing how to trade the national indexes, as these are the most straightforward indexes to trade and the ones you will most commonly find as tradable instruments on broker platforms.

Steps to Trading a Stock Index

In order to trade a stock index, the trader will have to open an account with a suitable broker. Today, traders can choose between hundreds of brokers that offer index-based CFDs or ETFs. Some examples of brokers that offer stock indexes as online trading instruments are as follows:

  1. FXCM
  2. FxPro
  3. Forex.com
  4. Interactive Brokers
  5. Saxo Bank

All brokers are required by law to know their customers, so traders are required to submit identification documents which prove their identity (international passport, drivers license and national ID card) and their place of residence (credit card statement, bank statement or utility bill). When these documents are submitted and approved, the account will be activated and the trader is ready for trading.

Leverage and Margin Requirements

Trading stock indexes requires more margin than forex trading because of the increased contract sizes to be traded. Many platforms will offer just the half contract (known as E-mini), so you will probably see E-mini Nasdaq, E-mini Dow, etc on your trading platform. However, traders who have more money to spare and who utilise brokerage platforms offered by banks such as Saxo Bank or MIG, will probably be offered the full contract. Whatever the case, the trader will need at least $20,000 to be able to trade stock index instruments comfortably. Some brokers offer watered down contract sizes, so you may be able to trade these index assets with as low as $2,000.

Trading Times

The parent exchanges of the stock index futures are usually open at certain hours of the day, during which the index assets experience their greatest volatility. This is similar to the forex market which is most active at certain hours of the day despite the 24-hour nature of the market. Traders should therefore pay attention to the times at which the parent exchanges are open for business.

Index Trading Strategies

Stock indexes can be traded by technical and/or fundamental analysis.

When trading with technical analysis, traders should understand that the parent markets are only open for certain hours of the day, even though the stock index futures themselves (which is what is offered for trading on the platforms) remain open for trading throughout the day. So traders must be conversant with the trading times of the parent exchanges as those are the times when there is maximum activity on the index assets. These are the times when there is maximum volatility and when traders have the opportunity to profit.

Technical analysis will involve the use of chart information and technical indicators to determine where the asset is headed. An example is this chart of the Xetra DAX30, showing a bullish continuation pennant pattern.

This is an example of a chart pattern being used as part of technical analysis in trading stock indexes.

The use of fundamental analysis in trading stock indexes involves being able to gauge market sentiment, because market sentiment is what will determine whether traders and investors will go on a stock buying spree, or whether they will ditch stocks for cash. Certain news items have a profound effect on the stock markets. These include employment reports (especially the Non-Farm Payrolls), manufacturing data, interest rate decisions and other country-specific news items. For instance, the Eurozone has been grappling with the sovereign debt crisis for quite some time and whenever there is talk of the state of the banking system in the affected countries, the major European stock indexes experience increased volatility.

In practice, trading stock indexes will require a combination of fundamental analysis and technical analysis. Looking at our chart example above, the fundamental driver for the Xetra DAX was the announcement by the European Central Bank that it would engage in bond buying as a means of limiting the effects of the sovereign debt crisis in the Eurozone. With this fundamental trigger, the bullish continuation pattern (pennant) provided a sound basis for a technical entry in the direction of the fundamental trigger.