The capital markets have a range of products that provide an investors different risk profiles. Most products which include, bonds, commodities and currencies, focus on specific movements in one area. Indices on the other hand provide and investors with a wide range of risk which is exposed to the equity markets. The risk is generally geared to higher risk assets that will perform well when interest rates are stable and growth is moderate.
What is index trading?
An index is generally made up of a group of stocks and is based on a calculation that changes during every minute that stocks are open for trading. For example, the S&P 500 index is a market cap based index where the larger stocks have a greater influence on the movement of the overall index. Specific large stocks can have a strong influence on an index. For example, the Dow Industrials has large stocks such as Exxon Mobile and Chevron Texaco which can be influenced by the price of oil. If energy shares are having a bad day, the Dow Industrials are likely to feel the pain of declining energy stocks.
Indices allow traders to take many types of positions. Investors can take directional position where they can buy and sell the index looking for a change in price, or they can take pair positions where the purchase one index and simultaneously sell another index. A pair trade is a market neutral trade where the invest is not exposed to the direction of the overall market, but instead is exposed to the relative change in one index compared to another. For example, if you purchase the S&P 500 index and sold the DAX, you would benefit if U.S. stocks outperformed Germany stocks. Pair trades such as the S&P 500 versus the DAX allows and investor to take on a macro trade that is similar to purchase the Euro and selling the U.S. dollar.
Put & call options
Many forex traders will also take options position on indices. A call option is the right but not the obligation to buy a stock at a specific price on or before a certain date. Options trading is very popular as your risk is defined to the premium you pay for the option. A put option is the right but not the obligation to sell an index at a specific price on or before a certain date.
Most indices have a broad array of sectors incorporated within them. There are some, like the Nasdaq 100 that are focused on a specific industry. The Nasdaq 100 is heavily weighted toward the technology sector. So if you are interested in either buying or selling that specific space, you can use the Nasdaq 100 to speculate on the future direction of this area. Additionally, you can take sector pair trades by using the Nasdaq 100 by generating a pair trade.
The benefits of trading an index is broad. You can take a macro bet on the direction of a market, or take a sector bet. Indices provide the ability to take market neutral bets using pair trades, or option bets where you mitigate your risk. However, you use indices; they should be part of an active trader’s arsenal.