A great way to boost your trading portfolio is learning how to trade indices. When trading indices, you effectively get a basket of stocks without the need to choose individual stocks. Indices represent different market segments, and trading them is considered a form of diversification. 

In this article, we’ll show you how to trade indices, explain the essential concepts, provide examples to make it easier to understand, and show you the 10 indices you should be trading. 

You can be a beginner or an expert wanting to refresh your knowledge, either way, this article will help you understand how to trade indices. 

How to Trade Indices: Understanding the Basics

Before getting into the mechanics of how to trade indices, it’s important to understand what an index actually is: An index is a measure of how a basket of stocks within a specific market or sector is performing. 

For example, the S&P 500 index tracks the performance of the 500 largest publicly listed US companies on US stock exchanges.

The Size of the Indices Market

The liquidity of indices markets is immense, with trillions of dollars worth of trading taking place every day. 

This liquidity means that traders who buy and sell indices can enter and exit their positions with ease. 

In other words, the indices market is fair. Trading indices allow you to speculate on the overall direction of a market or sector, rather than focusing on the performance of individual stocks.

How to Trade Indices: Key Terms You Need to Know

1. Index

 An index is a statistical measure of changes in a basket of stocks that represents a portion of the whole market. The S&P 500, the Dow Jones Industrial Average (DJIA), and the NASDAQ Composite are examples.

Real-Life Application

If you think that the US economy will do well, you might be interested in buying shares of the S&P 500 index, which tracks the performance of 500 leading US companies.

2. Futures Contract

 An index futures contract is an agreement to buy or sell an index at a certain price by a certain date in the future. The objective of futures contracts is to speculate on the future direction of the market.

Real-Life Application

If you think that the S&P 500  index is going to rise in the next three months, you can buy an S&P 500  futures contract. If the index rises, you sell the contract back to the exchange and make a profit because the new buyer is willing to pay a higher price than you originally paid.

3. ETF (Exchange-Traded Fund)

An ETF is an investment fund, traded on exchanges like normal stocks, and it typically tracks an index, exposing you to the performance of that index.

Real-Life Application

If you are interested in speculating about the performance of the NASDAQ 100 index, you can buy shares of an ETF that tracks that index (think Invesco QQQ ETF), among others.

How to Trade Indices: Getting Started

Choosing a Broker

 Choosing the right broker is of utmost importance to your success as a trader. You will need a broker with a good reputation, low spreads, a robust trading platform, and regulation by a reputable financial regulator.

Opening a Trading Account

 When you decide on a broker, you’ll need to open an account. That means providing identifying information, verifying your identity, and then funding your account. Demo accounts are offered by most brokers, as well.

With virtual money, you can learn how to trade before risking your own.

Developing a Trading Strategy

 It will also help to have a distinct trading strategy. Your strategy specifies how you will enter and exit trades, how much you will risk on each trade, and the kinds of analysis you will use to inform your trading. 

You might use technical analysis, which focuses on price charts and price patterns, or fundamental analysis, which looks at economic indicators and news events.

How to Trade Indices: Top 10 Indices to Trade

1. S&P 500

 Since its introduction in 1957, the S&P 500 has listed 500 of the largest publicly traded companies in the country, representing a variety of industries. The index is considered highly liquid due to its broad market coverage.

2. Dow Jones Industrial Average (DJIA)

 The DJIA consists of 30 blue-chip companies from different sectors of the US economy. It is one of the oldest and best-known indices.

3. NASDAQ 100

 The NASDAQ 100 is an index that tracks 100 large non-financial companies traded on the NASDAQ stock exchange. It is overweighted in the technology sector.

4. FTSE 100

 The FTSE 100 index is a measure of the 100 biggest companies listed on the London Stock Exchange. It is a leading measure of the UK stock market. 

5. DAX 30

 The DAX 30 index represents the 30 largest and most liquid companies listed on the Frankfurt Stock Exchange and is a proxy for German market performance.

6. Nikkei 225

 The Nikkei 225 is a stock market index consisting of 225 of the largest companies listed on the Tokyo Stock Exchange. The index is a key measure of the Japanese stock market.

7. CAC 40

 Companies included in the CAC 40 index are constituents of the Paris Stock Exchange. This index represents the French stock market.

8. Hang Seng Index

 The Hang Seng Index is comprised of the biggest companies listed on the Hong Kong Stock Exchange and is considered a benchmark of the Hong Kong stock market.

9. ASX 200

 The ASX 200 consists of the 200 largest companies listed on the Australian Securities Exchange and represents the performance of the Australian stock market.

10. Russell 2000

 The Russell 2000 is an index that represents the 2,000 smallest companies by market capitalization in the US, often used as a benchmark for small-cap performance.

How to Trade Indices: Analyzing the Market

Technical Analysis

 It is the study of price charts and indicators to predict future price movement. Popular tools include moving averages and relative strength index (RSI) retracements.

Real-Life Application

 You might see a ‘double bottom’ pattern on the S&P 500 index and expect a change in trend, then place a trade to profit from the expected price movement.

Fundamental Analysis

 Fundamental analysis looks at economic data, political events, and market sentiment to estimate the value of a market index. Indicators include GDP, unemployment levels, and interest rates.

Real-Life Application

Say that the U.S. Federal Reserve announces a reduction of interest rates, which is interpreted as positive for market sentiment. 

You might see prices of the DJIA move up. You could buy or sell the DJIA to take advantage of this movement.

Sentiment Analysis

For example, sentiment analysis, which reveals the mood of a market when it comes to traders and investors, can be analyzed with the Commitment of Traders (COT) report and social media sentiment.

Real-Life Application

 Based on the reasoning behind momentum strategies, if sentiment indicators reveal that traders are excessively bullish on the NASDAQ 100 index, then the up-trend is possibly set to continue. 

How to Trade Indices: Managing Risk

Setting Stop-Loss and Take-Profit Orders

These are called stop-loss orders, and they close your trade if the market moves against you by a specific amount (the ‘stop’).

 On the other side, there are take-profit orders, which close your trade for a specific profit.

Real-Life Application

For example, you could purchase an ETF that tracks the S&P 500 index for $300, place a stop-loss order at $290 to minimize losses, and place a take-profit order at $310 for a modest profit.

Position Sizing

This refers to the concept of position sizing: how much capital to allocate to any one trade? A general rule is to risk no more than 1-2% of your trading capital on any one trade.

Real-Life Application

So if your trading account is $10,000, and you decide to risk 2% per trade, you will risk $200 per trade. This helps you manage risk and your capital.

Diversification

 Spreading your bets over multiple indices, essentially diversifying the risk of individual trades, can help minimize your risk should unfavorable market movements occur. 

Never put all your capital into one trade.

Real-Life Application

 You might buy the S&P 500 index, the DJIA, and the NASDAQ 100 to spread your risk among different markets.

How to Trade Indices: Staying Informed

Keeping Up with Market News

Index traders keep an eye on market news and events to track indices. Economic calendars and news websites inform us about what is going on in the economy and what economic events might affect the indices.

Real-Life Application

If you see that an economic calendar has an entry for a Federal Reserve meeting coming up, for example, you might decide to postpone some trades until after the interest rate decision, because these can cause major fluctuations in markets.

Continuous Learning

The index market is always changing, so learning never stops. Attend webinars, read books, and subscribe to trading groups.

Real-Life Application

By watching webinars presented by experienced traders, you can learn new techniques and find out how the market is behaving nowadays.

How to Trade Indices – Is it right for you?

Learning how to trade indices can be quite an adventure, as there’s a lot of opportunity in that space. 

However, at the same time, it’s not as risky as some other forms of trading. By learning the fundamentals of how the indices market works, finding a broker you can trust, strategizing and trading, and staying up-to-date, you can become an indices trader with confidence. 

As long as you’re prepared to manage the risk, take the time to continuously educate yourself, and practice, you can become a successful trader of indices. 

How to trade indices allows you to explore a fascinating market, as long as you approach it with knowledge and patience.