Your guide to 5 top stock market index trading strategies

5 top stock market index trading strategies

1. Trend trading
2. Trading retracements
3. Trading reversals
4. Trading with momentum
5. Trading breakouts

Some of the most popular markets in the world are indices, where significant gains, as well as substantial losses, can be made by those with a good trading strategy. However, what many don’t realise is that certain strategies are better suited to index trading than others.

Remember that the best trading strategy is like a fingerprint – unique to you – and will include a blend of fundamental and technical analysis that fits your trading style, preferred trading indicators, and risk management strategy.

Trend trading

This is one of the simplest strategies to understand, in theory: predict correctly which way the market is going and capitalise on an index’s upward or downward spike or a change of direction.

In trend trading, it’s important to establish the direction of a trend before taking a position, as these movements can occur suddenly (such as in the case of a temporary spike) or incrementally.

The most successful trades are ones that enter a trend while it’s still developing and then close their position as close as possible to the highest point to take profit.

To achieve this, you’d utilise several technical indicators to minimize the risk of potential losses. These indicators may include temporary price movements against the prevailing trend of the index price, which will be discussed below.

Trading retracements

Markets, including indices, never move in a straight line. When a trend in an index price emerges, what often occurs is referred to as a ‘pullback’ or a retracement. This is when the index’s pricing temporarily reverses its direction.

This can either be a temporary increase in the price of an otherwise downward trending index or a decline in the price of an upward trending one. The latter is often particularly important to watch out for because trading retracements as a strategy is commonly used in bullish environments.

Stock markets generally exhibit an upward trend over time, but they still experience volatility. The general principle is to wait for a momentary drop or rise in the index price. Then, go long (if the index price dropped) or short (if it rose) once the temporary retracement is over. This approach enables you to capitalise on the momentary price move. As a result, this strategy is most often used by scalpers and other shorter-term styles of trading.

It should be noted, though, that indices can also undergo a reversal, which is when the underlying index’s market price changes its overall direction (from bullish to bearish or vice versa). Therefore, it’s important for you to confirm whether the retracement is a temporary move when trading a retracement strategy.

Trading reversals

What might initially appear as a retracement could actually be a 'reversal', in which case you’d likely prefer to sell the index. A reversal represents a fundamental change in the overall direction of an index’s price for a certain period of time.

In an uptrend, an index’s price would undergo a series of higher highs and higher lows. A reversal of this trend would be a prevailing downtrend, characterised by the index’s price forming a series of lower highs and lower lows.

The opposite is also true in the case of a downtrend, where the index’s trading price would exhibit spikes into higher and higher peaks. This signifies an overall shift in the index’s pricing from a downward to an upward trend.

Certain indicators, such a moving average, oscillator, or channel, may help in isolating trends as well as spotting reversals.

Trading with momentum

The motto of someone with a momentum trading strategy can be summarised as: ‘buy high, sell higher’. A momentum index trading strategy involves traders following the market trend and purchasing securities that are experiencing upward momentum, and then selling them when they appear to have reached their peak.

The aim here is to capitalise on volatility by identifying buying opportunities within short-term uptrends and then selling when the securities start to lose momentum. As such, it’s often most suitable if you’re a scalper, day trader, or use other shorter-term trading styles.

Trading breakouts

Similar to trend trading, a breakout trading strategy entails closely observing indices to identify patterns, rhythms, and indicators of volume, volatility and direction. With this knowledge, you’d aim to enter a trend as early as possible when an index’s price breaks through its usual levels of support and resistance, then trade that trend.

If you use this strategy, you can look for price points that indicate the start of a period of volatility or a change in market sentiment for an index. Additionally, you may consider placing a limit-entry order around the identified levels of support or resistance, allowing any breakout to automatically execute a trade.

Learn more about trading strategies

How to choose the best index to trade

Choosing the right index to trade isn’t easy, and experts have different methodologies for making such decisions. Factors such as the size of the index, its volatility and overall performance, and the market hours of the country in which it’s domiciled will all impact your decision.

When selecting an index to trade, it is important to consider that each index has its own characteristics and represent a different set of stocks. For example, the S&P 500 index tracks the largest public companies in the US by market capitalization, the Russell 2000 index tracks small and medium-cap stocks, while the Nasdaq 100 predominantly tracks US technology shares. Even though all three ostensibly tracking US shares, they have distinct focuses and compositions.

This is important because stocks within each index can react differently to economic conditions. It is imperative to understand the constituent companies and how their share prices are influenced by macroeconomic factors and index-related circumstances.

With this guidance, you’d choose an index based on the national economy, global stocks, economic sector, or basket of stocks in which you want to take a position. Since knowledge is crucial in trading, you’d likely pick an index representing an industry you are familiar with and interested in keeping up with the latest trends and news. Additionally, you’d also take into account your risk appetite as different indices experience different levels of volatility.

Ultimately, there is no ‘best index’ in the world from an absolute, objective perspective. However, there is often the most suitable index for research, analysis, and practice purposes.

To get you started in your search, here are some of the world’s most popular indices for traders:

How economic events affect indices

Macroeconomic events greatly affect the pricing of an index in the most cases. This is due to the nature of indices. While a company’s share price is influenced by internal company news and external events in the broader economy, the performance of indices is tied to the share prices of multiple stocks.

Anything that may affect the performance of companies' fundamentals on both macro and micro level (like the cost of borrowing, inflation, employment levels, a company’s latest earnings, industry supply chain shocks, and more) could produce changes in the index level.

In fact, economic events have such a significant impact on indices that economists and analysts consider them as barometers for assessing the financial health of a sector, a country, and even the world.

Good news will increase investor confidence, potentially indicating an upward movement in the prices. Conversely, bad news could lead to investors withdrawing from stocks to shift their wealth into 'safe havens' like gold. This can affect you as a trader, as reduced demand may cause a decline in stock prices and consequently affect the index.

Using financial calendars will help you stay informed about these types of events. However, it’s important to bear in mind that different indices may respond differently to economic variables, so reading solely the headlines isn’t sufficient.

We also provide trading signals for a wide variety of markets. Trading signals are actionable ‘buy’ and ‘sell’ suggestions that are sent to you based on emerging chart patterns and key levels being met. This allows you to leverage your knowledge of economic events and their impact on an index to your advantage.

How to trade or invest in indices

1. Select your preferred index
2. Conduct thorough market research
3. Open a live account or practise on a demo
4. Take steps to manage your risk
5. Place your deal and monitor your position

When trading with us, you can go long or short on our range of indices using contract for difference (CFDs). This type of trading involves leverage, which means you only need to provide a fraction of the total value of your trade as an initial outlay. This initial outlay, is called your margin, and is a small percentage of the trade’s total size, while the remaining amount is essentially borrowed from the lender (that’s us.)

Leverage allows you to open a larger position with only small amount, but it also carries greater risk, both in terms of potential profits and losses. This is because both profits and losses are calculated based on the full trade size, rather than your margin amount.

You can also trade on indices for longer with our out-of-hours index trading.

Trade indices on the spot

You can predict on indices in real time via spot (cash) trading. Here, you can get continuous, up-to-the-second pricing to take a position on your index’s current price as soon as market moves happen.

Trade futures on indices

Another type of agreement you can enter into to predict on indices is trading options. This is a contract that gives you the right, but not the obligation, to predict the direction in which an index’s price will move within a certain timeframe, by a specified expiry date.

With us, you can trade with options on some of the biggest stock indices in the world, including the FTSE 100 and Wall Street.

It’s important to note that options are leveraged, much like CFDs are. This means that profits can be magnified, as can your losses, if you’re selling options. When buying call options via CFDs with us, you can never risk more than your initial, just like trading an actual option. However, when selling call or put options, your risk is potentially unlimited.

5 top stock market index trading strategies summed up

• There are 5 most popular index trading strategies. These largely involve trading trends, breakouts, retracements, and volatility in an index
• Indices are inextricably linked to market events, but they don’t all respond to the same events in the same ways
• With us, you can trade on indices via CFDs in real-time or using options and futures