Stock index trading strategies
 

In the penultimate lesson of this course, we will look at which strategies and trading styles are effective when trading stock indices.

1. Indices vs Other Markets
2. Which trading styles work for indices?
3. Shorts and corrections

Indices vs Other Markets

Stock indices behave differently from other financial markets.

Compare the performance of the S&P 500, Wall Street, and DAX with gold and the euro-dollar in 2010. You will see significant differences in their behavior.

This difference is due to the fact that a stock index reflects the performance of groups of stocks influenced by economic factors, while commodities such as gold and currencies such as the euro-dollar react to different economic and political conditions.

Such a chart can show that while stock indices may exhibit growth during economic expansions, commodities and currencies may react entirely differently, depending on current events and changes in monetary policies.

Apart from a few periods of growth spurts, stock indices follow one clear trajectory: upward. In contrast, currencies and commodities behaved much more steadily during this period.

This is not surprising when considering what indices represent. They reflect the economy, which tends to grow despite occasional recessions. Likewise, indices tend to rise over time.

For example, over the last 30 years, from 1990 to 2020, the FTSE 100 recorded positive annual returns in 19 instances, while the DJIA and DAX achieved this 22 times.

Which Trading Styles Work for Indices?

Despite – or perhaps because of – their differences from stocks, currencies, and commodities, indices are used by traders with a variety of styles.

Thanks to stable returns, they are popular among long-term position traders. Through investments such as exchange-traded funds (ETFs), these traders can take a position on an entire index without having to purchase individual stocks.

However, the price movement of an index is never completely predictable. This is why traders employ other approaches. Swing traders, for example, can take advantage of the regular oscillations of an index to generate profit. A typical swing trade on an index might involve waiting for a price drop after a trend break and then buying before the movement resumes.

Technical indicators, such as Bollinger Bands, can also be used. If an index falls below the lower band and enters oversold territory, it may signal a return to growth and provide a buying opportunity.

Short-term traders, such as day traders and scalpers, often focus on indices. They use CFD contracts to capitalize on the high volatility offered by major global indices. Most of them, however, structure their strategies around different types of movements.

Shorts and Corrections

What happens if a stock index enters a bear market? Stock market crashes and index corrections can present traders with an attractive opportunity for a “big short” that could yield substantial profits.

Examples:

• During Black Monday in 1987, the Dow Jones and S&P 500 lost more than 20% of their value in a single day.
  
  

• In the 2008 crash, the DJIA dropped by 1,800 points in one week. Over 17 months, it lost 54% of its value.
  
  

• In 2020, COVID-19 fears triggered the steepest drop since 1987. The FTSE fell 10.8% in one trading day, while the DAX fell 12.2%.
  
  

These declines were much sharper than the preceding rises. A well-timed short position before any of these events would have delivered huge profits. Traders often say that indices “go up by escalator, but down by elevator.”

Timing, however, is critical. Markets can remain at irrational highs for long periods, and analysts may predict a correction months or even years before it actually occurs. Shorting and waiting for a drop is possible, but traders must ensure their losses do not exceed a level that triggers a margin call, potentially closing the position before the expected profit is realized.

Predicting the exact timing is extremely difficult, but there are tools traders use to spot warning signs. The Volatility Index (VIX), for example, uses options to measure the current price of fear in the market. A high VIX may indicate that sellers are about to take control.

Another sign is a sharp rise in P/E ratios, which some view as a signal of a market bubble likely to burst soon. Again, however, this tool will not tell you exactly when.