Many traders today opt for cash indices, simply because these are liquid instruments and, when compared to stocks, they post more contained daily ranges. However, as you probably know, indices are actually bundles of stocks, and as a result, the performances of both asset types are heavily intertwined.
This can be a challenge for you, especially during a period when volatility is so elevated. We’ve witnessed just recently how bank stocks got crushed, putting pressure on the broader markets. Hence, a few tips on how you can approach trading signals on indices can be very helpful these days, mainly because you truly need to constantly monitor a whole lot of variables.
Trading cash indices
Indices are averages calculated based on price, such as the Dow Jones Industrial Average, or the stock’s market capitalization such as the S&P 500, Nasdaq, or DAX40.
Traders who buy or sell indices gain exposure to a list of blue-chip stocks by using a single instrument. This is an effective method to ride the overall market trend, since it is determined by leading and dominant shares.
When there is a clear trend in place for the majority of index constituents, the index posts a well-defined direction. The challenge arises when stocks post divergent price returns, potentially leading to a choppier index performance.
Is technical analysis enough?
The most important factor, out of all the tips for trading cash indices that you can get, is that you need to know that technical analysis alone does not suffice. While indices do react to certain support/resistance levels, false breakouts and overshooting price action can occur.
In such situations, you need to back technical analysis with a more granular approach, which implies taking a closer look at the stocks that are part of the index. The majority of popular stock market indices (SPX, NDX, FTSE100, DAX) are cap-weighted, so the stocks with the largest capitalization have a higher weight on the index’s performance.
With that being the case, a few major stocks could drive the index up or down, even if smaller names post a divergent performance. The current situation is a great example of that matter. The S&P 500 is currently trading around 4,000. Many experts, though, are scratching their heads, expecting it to trade a lot lower, considering risks for a recession, tight monetary policy conditions and geopolitics.
Yet, the S&P 500 defied all assumptions, and has been trading mostly on the way up since the start of 2023. The main reason for that is the largest stocks that are part of the index. Apple, Microsoft, and Tesla rose this year, and since the tech sector has a weight of 25% in the index, it drove the entire bundle higher.
Monitoring underlying instruments
As a result, you need to monitor the underlying stocks, especially those with a large capitalization. They have the ability to have a material impact on the index. This adds an extra safety layer on top of technical analysis, showing you when a trading signal has a higher probability of success. If the larger stocks are heading in the same direction as your signal, then it’s likely you are positioning properly.