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 great gains, and also sizable 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 the 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.

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

The most successful trades are ones that get in on a trend while it’s still building and then closing their position as near as possible to the highest amount of take-profit.

To do this, you’d use a number of technical indicators to guard against the potential of making a loss as much as possible. These, for example, might include temporary moves against the prevailing index price trend, which we’ll cover below.

Trading retracements

Markets, including indices, never move in a straight line. When a trend in an index price emerges, what will very often happen is something called a ‘pullback’ or a retracement, which is when the index’s pricing temporarily experiences a reversal of direction.

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

Stock markets tend to trend upwards over time, but nonetheless experience volatility. The rule of thumb here 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’ll enable you to buy the momentary price move. For this reason, it’s most often used by scalpers and other shorter-term styles of trading.

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

Trading reversals

What might at first look like a retracement could actually be a 'reversal', in which case you’d likely prefer to sell the index. This is a fundamental change in the overall direction of an index’s price for a time.

In an uptrend, an index’s price would go through a series of higher highs and higher lows. A reversal of this would be a prevailing downtrend, characterised by the index’s price changing to a series of lower highs and lower lows.

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

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

Discover the top 10 trading indicators every trader should know

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 is one in which investors quite literally go with the flow and buy securities that are rising, then sell them when they look to have peaked.

The aim here is to work with volatility by finding buying opportunities in short-term uptrends and then sell 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 involves watching indices closely to determine their patterns and rhythms in terms of volumes, 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’ll look for price points that indicate the start of a period of volatility or a change in market sentiment on an index. You may also place a limit-entry order around the levels of support or resistance you’ve identified, so that any breakout executes a trade automatically.

Learn more about trading strategies

How to choose the best index to trade

Ultimately, there is no ‘best index’ in the world from an absolute, objective perspective. There is often, however, the best index for you – something only you can determine through thorough research, analysis and practice.

Choosing the right index to trade isn’t easy, and experts differ as to what methodology to use when making your decision. The size of the index, its volatility and overall performance, plus the market hours of the country it’s domiciled in will all affect your decision.

When choosing which index to trade, remember that each one has its own characteristics and represent a different set of stocks. For example, while the S&P 500 index tracks the US’s biggest public companies by market cap, the Russell 2000 index tracks small and medium cap stocks, while the Nasdaq 100 predominantly tracks US technology shares. Even though all three ostensibly track US shares, they have very different focuses. With us, you can also trade the ASX (the Australian Stock Exchange) which tracks the largest 200 companies by market cap in Australia.

This is important, because stocks within each index will react differently to economic conditions. Understanding the constituent companies – and how their share prices are influenced by macro and index-related circumstances – is imperative.

With this guiding you, you’d choose an index based on which national economy, global stocks, economic sector or basket of stocks you want to take a position on. As knowledge is power when it comes to trading, you’d likely pick an index representing an industry you know about and in which you’re interested in keeping up with the latest trends and news. You’d also take into account your risk appetite, as different indices experience different levels of volatility.

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 an index’s pricing in most cases. This is because of the nature of indices. While a company’s share price will be affected by internal company news and external events in the wider economy, indices’ performance tracks the share price of many stocks.

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

In fact, economic events have such a material impact on indices that economists and analysts consider many a barometer for the financial health of a sector, a country, and even the world.

Good news will increase investor confidence, possibly indicating an upward spike. Conversely, bad news could result in investors pulling out of stocks to transfer wealth into 'safe havens' like gold. This lessened demand could see a drop in stock prices, and therefore drops in the index.

Using financial calendars will help you keep an eye on these kinds of events. However, it’s important to bear in mind that different indices will respond differently to economic variables – so reading the headlines isn’t enough.

We also provide trading signals on a wide variety of markets. Trading signals are actionable ‘buy’ and ‘sell’ suggestions sent to you, based on emerging chart patterns and key levels being met, so you can use your knowledge of economic events and how they affect an index to your advantage.

How to trade or invest in indices

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

When trading with us, you can go long or short on our range of indices using CFDs. This is a leveraged type of trading, meaning you put down a percentage of your trade’s total value as an initial outlay. This outlay is called your margin, and is a small percentage of the trade’s total size, while the rest of the amount is put up by your broker initially, enabling you to open a position greater than your initial outlay.

Leverage means you only need a small amount to open a larger position, but it also carries greater risk of both profits and losses. This is because both will be calculated based on the full trade size, not your margin amount.

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

Trade indices on the spot

You can speculate on indices in real time via spot (cash) trading. Here, you’ll 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

If you want to take a more macro, long-term view, you can trade index futures using CFDs. This means you can speculate long or short on an index. You’ll then enter into an agreement with the broker (that’s us) to exchange an underlying market (your index’s market price) for a fixed amount at or by that futures contract’s expiry date.

Trade options on indices

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

With us, you can trade with options on some of the biggest stock indices in the world, including the Australia 200 (commonly referred to as the ASX 200), FTSE 100 and Wall Street.

It’s important to note that options are leveraged products like CFDs are. This means profits can be magnified – as can your losses, if you’re selling options. When buying call options using CFDs with us, you’ll never risk more than your initial payment when buying, just like trading an actual option. However, when selling call or put options your risk is potentially unlimited (although your account balance will never fall below zero).¹

Invest in indices

Unlike with companies, you can’t take ownership of any actual shares with indices. However, if you want to invest, you still can. When you have a share trading account with us, you can do so via an index-tracking ETF.

Exchange traded funds (ETFs) track the performance of their benchmark index. Just like shares, it’s on an exchange and you’ll own the asset (in this case, the investment fund) outright. However, where shares only allow you to invest in one company, ETFs give you broad exposure of an entire index’s performance.

You can also invest directly in the shares of the companies listed on any given index – we have over 13,000 to choose from.

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 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
• You can also invest in indices’ performance by buying index-tracking ETFs on our share trading platform

Footnotes:

¹ Negative balance protection is not available to Pro Level 2 clients or Pro Level 1 clients with collateral enabled.