Four reasons to add index trading to your investment strategy

Index trading has become popular among traders looking to escape individual company risk or protect a portfolio of stocks from adverse market movements.

Shaun Murison, senior market analyst at IG Markets South Africa, is here to guide us through the intricacies of index trading.

What is an index?

It is a basket of stocks, usually weighted by market capitalization. Rather than buying individual stocks in a particular market, you can buy the index. In the case of IG Markets South Africa, we offer several indices in the form of a derivative called Contract for Difference or CFD. In fact, what you are buying is the price movement of the index.

What are some of the most popular indices used by traders?

The most popular is the Nasdaq, mainly because it has quite good volatility. The Nasdaq is the preferred exchange for tech stocks, and these tend to move quite aggressively, which is something traders like.

Other popular indices used by traders are the German Dax, FTSE 100, Dow, S&P 500 and of course the FTSE/JSE Top 40 Index. We have different names for these clues.

Index name Equivalent IG Markets
Nasdaq USA Tech 100
Dax Germany 40
Dow Wall Street
S&P500 500 United States
FTSE/JSE Top 40 SA 40

We also have thematic indices such as a Cannabis Index (based on the highest rated cannabis stocks), a FAANG Index (composed of Facebook, Apple, Amazon, Netflix and Google/Alphabet) and an Emerging Markets Index, just to name a few.

What are your top three reasons for adding index trading to your investing arsenal?

In fact, I have four.

This is a way to avoid individual business risks. Because you are buying an index that is an average price made up of several underlying components, you benefit from diversification. If you were to buy the underlying stocks individually, it would be far too cumbersome for the average investor and far too expensive.

You can go long or short, so you can trade the market both ways. This is what traders love, and for those with stock portfolios, shorting the index that best matches your portfolio composition is one way to hedge your portfolio.

You have a variety of indices to choose from and the costs are low compared to stock trading. At IG Markets, we do not charge commissions, so traders only pay the spread fee. The spread is the difference in price paid by buyers and sellers of a financial instrument and this is how brokers make money. The spread tends to be very small, but varies depending on market liquidity. In other words, the more people trading the index, the lower the likely cost. It is certainly much cheaper than a direct stock purchase.

You can leverage your trades up to 30:1. This means you get bigger profits – or losses, if the trade goes against you – for the amount of money invested. Leverage (or gearing as it is also called) is a double-edged sword. It’s fine when you call the direction of the trade correctly, but you have to be careful to get out of a trade quickly when it goes against you.

How do I know what I’m buying when I trade an index?

The constituents of each index and their weighting in the index are subject to constant change.

The table below shows the top 10 constituents of the FTSE/JSE Top 40 Index in February. You can see that BHP and Richemont are the main constituents with just over 13% by weight each. At one point, Naspers made up 25% of the index, so you’d want to have a pretty positive view of Naspers if you wanted to buy the index. Today, Naspers only represents 5% of the index. You will also notice that the major constituents are largely commodity or currency producing companies, which is a solid hedge against a weak rand.

Source: FTSE/JSE

Is index trading for everyone?

Probably not. It would suit those with a more short-term view of market movements and as such should probably not represent more than around 25% of your total portfolio. It can certainly be used very effectively to insure your stock portfolio against an adverse move. For those who love volatility, index trading can be a useful addition to your toolkit.

Is index trading riskier than buying stocks directly?

No, because the index spreads your investment over several equity positions so that you benefit from diversification. This makes the index less volatile than direct equity exposure, but keep in mind that index trading involves higher leverage, which can increase risk. Your profits will be magnified if you call the direction of market movement correctly, but your losses will also be magnified if you get it wrong. You should therefore invest with correct position sizes and record profit and stop loss levels as part of a basic risk management strategy.

About IG Markets South Africa: IG Markets South Africa was established in 2010 and is regulated by the Financial Sector Conduct Authority (in South Africa) as an OTC Derivatives Provider and Authorized Financial Services Provider (FSP No. 41393). It has an office in Sandton to serve its thousands of South African customers. Its board of directors and senior management in South Africa are largely made up of South Africans, making it a truly South African operation. As one of the largest employers in the online brokerage category, it is proud to play a leading role in the growing financial services industry in South Africa.

Note that losses on CFDs can exceed your deposits.

IG Markets is part of the LSE-listed IG Group, which has a market capitalization of £3.4 billion (R71.4 billion). It has more than 330,000 active customers worldwide.

Brought to you by IG Markets South Africa.

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