How to Trade the Index

3d blue stock chart

The index is the most commonly used measure when it comes to describing the movement of a market. Watch the finance update on any news bulletin and it’s often the first thing they refer to. For example, ‘The market was up 50 points’, or, ‘the market was down 70 points’ — you’ll hear something along those lines every day.

Straight away it gives you a reference point; a summary of the day’s action. Of course, it’s just that — a summary. There are still shares that trade against the index trend.

Where an index can really be useful, though, is measuring the performance of a portfolio. Especially if you’re paying a fund manager to beat it. After all, if an active manager only matches the performance of the index (or underperforms it), you could be better off parking your funds in an index hugging ETF —paying only a fraction of the fees.

Something not everyone realizes, though, is that you can also trade the index. So rather than picking individual stocks, you can use the index to trade the direction of the market. But how do you go about it?

You’re probably already familiar with ETFs that do this for you. There are a number of popular ones, including SPDR S&P/ASX 200 [ASX:STW] and iShares S&P/ASX 200 [ASX:IOZ]. Both allow you to get exposure to the index through the one holding.

Typically, though, investors don’t trade in and out of these types of ETFs. Partly because most only allow you to trade in one direction — the ‘long’, or buy side. If you wanted to short the index, it then becomes a little bit harder.

There are ETFs that allow you to short the index. In effect, they work inversely to the direction of the market. The fund shorts the index by selling futures contracts on the ASX SPI (share price index) 200. So when you buy this ETF, you are actually shorting the ASX 200.

By using both types of ETFs — long and short — you can buy into the ‘long’ ETF when you think the market is going to rally. And if you think the market is going to reverse, you close the long position out and buy the ‘short’ ETF, repeating the process over.

Another way to trade the index is through the futures market. But setting up an account and getting started can be a pretty arduous task. And it’s leveraged. The main index product, the ASX SPI 200, trades at $25 per one point move in the index. Meaning that a hundred point move in the index will change the value of one contract by $2,500.

Another way to look at it is the total value of your position. It’s calculated by the index multiplied by $25. So if the index is trading at 5,000, your total exposure is $125,000 per contract. Probably something that will keep most people up at night!

Because of the leverage, you’ll also need to lodge $6,500 per contract. Given the amount of volatility we’ve seen this year, you can see how the futures market is not for everybody.

The ASX also runs a mini version of the SPI. It trades at $5 per one point move in the index; so a hundred point move in the index equates to a $500 move in the value of the contract. It’s still a $25,000 exposure, if we use the example of the index trading at 5,000, as per above. The margin is less at $1,300, but may still be beyond the reach of many.

Another way to trade the index is through contracts for difference, otherwise known as CFDs. There are a myriad of service providers, but typically an index CFD will trade on a $1 per one point move in the index. So a 100 point move in the index will equal a $100 move in the value of a contract, so perhaps a bit more realistic for many.

There are a number of reasons to trade the index. One of them is straight out speculation. You might believe the market is oversold and ready for a bounce, deciding it’s time to buy. Or, you think the market is overbought and due for a fall, so you decide to sell.

In practice, it’s no different to any other trade. You enter and exit at your target levels, running a stop-loss if you get it wrong. However, one thing that makes index trading appealing is that you can easily trade both directions of the market.

So, if you want to buy, you buy. And if you want to short the market, then you sell. You can go long or short with equal ease. Which is particularly helpful when it comes to the other reason for trading indexes — hedging.

Say you think the market might be about to fall. Rather than selling your shares, you could hedge your portfolio by short selling the index. Now it’s not going to be a perfect match. As I wrote in the beginning, shares can move against the index trend.

But if you owned shares in companies that make up the ASX 200, particularly the top 20 companies that hold a big weighting in the index, then selling an index can be one way to hedge. And it’s also flexible.

If you want to hedge your whole portfolio, then you can sell an equivalent amount in the index. Or, if you only want to partially hedge, then you might decide to only short sell half the amount. You can see how you can adapt it to different strategies.

Trading the index might not be for everybody. But the next time you’re watching the news and the finance report comes on, you’ll know that the index is more than just a barometer of the market. It is something that can be used for multiple purposes — trading both market directions, and hedging a portfolio.

Matt Hibbard,

For The Daily Reckoning

Matt Hibbard

Matt Hibbard

Matt Hibbard is Port Phillip Publishing’s income specialist. While most investors focus on making money in the short term, Matt takes a different view. He’s focussed on how you can invest today to grow wealthy in 10 or 15 years’ time. You can find more of Matt’s work over at Total Income where he’s hunting down the next generation of companies that could pay you more each year than you initially invest.

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