Indices Trading Strategies

When you trade an index, it’s wise to keep in mind that although you’re trading one entity (the Index itself) that entity is made up of a number of individual stocks which have been grouped together. Here are a few key points to focus on instead;

  • 01

    Monitoring Index Sectors

    There is no specific size for an Index; examples range from Germany’s DAX 30 all the way up to the Wilshire 5000 index. However, one of the first things to consider when trading an index in its entirety is – what are its component parts? Does it have a large number of stocks which are focused on a specific sector of the market?

    For example, more than 10% of the UK FTSE100 is made up of mining and energy stocks, meaning that a shift in commodity prices and the subsequent rise or fall of commodity-related stocks has the potential to affect the FTSE as a whole.

  • 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

    Changes to Indices

    Not so much a strategy as much as something to be aware of; the constituent stocks of an index can change over time. Companies can merge, meaning that two stocks converge into one; for example, in 2014 the UK firms Dixons and Carphone Warehouse merged and their previously separate stocks became one tradable entity, Dixons Carphone. Other companies may go bankrupt, leading to their stock no longer being tradable. A third option is that the company’s market cap shrinks to such a level that it is too small to remain on a specific Index (the FTSE 100, for example, tracks the UK’s 100 largest publicly traded companies). In such a case, it would be demoted in due course, whilst a company from a secondary index with a higher net worth would take its place.

  • 04

    The Link between Currencies and Indices

    Index traders would be wise to keep their eye on Forex rates; there are circumstances in which a weak currency leads to an index rising and vice-versa. Let’s take the example of the Nikkei225; in 2014 the value of the US Dollar soared against the Japanese Yen – earlier in the year the exchange rate had been around 1:102 whilst by the end of the year it was hovering at a level of about 1:120. However, at the same time the Nikkei225 went from strength to strength in 2014, moving from a 14-15k level to almost 18k by the end of the year.

    What’s the reason for this contrast between a country’s currency and its primary index? The answer is that the decline in the Yen’s strength may well have played an active part in the Nikkei’s rise. Japan’s economy is largely based on exports, and a weaker exchange rate for the primary currency benefits importers, since they can sell their products for a lower price in foreign markets whilst still making a similar profit on each sale in their own currency. In this case, the drop in the value of the Yen helped export-focused companies to perform more strongly, boosting individual stocks and therefore driving up the Nikkei as a whole.

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