Last Updated on November 13, 2022 by Oddmund Groette
If you have been following the stock markets around the world, you would be conversant with stock market indexes, such as the S&P 500, DOW 30, NIKKEI 225, DAX 30, STOXX 40, CAC 40, and FTSE 100. Ever wondered about stock market index trading strategies?
Stock market index trading refers to buying and selling a specific stock market index via a derivative instrument that tracks the index. The strategies traders use to speculate on whether the price of an index will rise or fall are known as stock market index trading strategies, and they include trend-following and mean-reversion strategies.
In this post, we take a look at stock market index trading strategies and a specific backtest is at the end of the article.
What are stock market index trading strategies?
A stock market index measures the price performance of a group of stocks that represent the broad market or an industry sector. Trading a market index allow you to gain exposure to an entire stock market or an industry with just a single position. But you cannot purchase an index directly — you trade it via an instrument that tracks its movement.
Generally, when you buy an index, you are not purchasing any actual underlying stock but rather the average performance of the group of stocks that the index represents. This is because an index represents the performance of a group of stocks. Index trading offers you the chance to speculate on the price movement of the major world stock market indexes.
There are a few different stock market index trading strategies that can help traders determine the best entry and exit levels. They include the following:
- Mean-reversion strategies
- Trend-following strategies
List of all stock market index trading strategies?
There are many strategies for trading a stock market index, such as the S&P 500, Nasdaq 100, Dow 30, and so on, but we will group them under mean-reversion and trend-following strategies.
The mean reversion strategy is one of the most common strategies for trading stock market indexes. Traders can use this method to profit from price corrections after the market price has deviated significantly from its mean. This strategy suggests that asset prices will tend to return to their mean following an extreme price move.
The concept of mean reversion is from the popular statistical concept known as regression to the mean, which Francis Galton first observed. The concept demonstrates that extreme events are frequently followed by normal events, as things tend to return to their normal state over time. To put it another way, the greater the value’s deviation from the mean, also known as outliers, the more likely it is that it will return to its more typical value.
The concept can be applied to any time series, including security prices, volatility, earnings, earnings growth rates, and technical indicator levels. In the case of a security’s price, the price tends to oscillate around the mean or average price, which is a pattern that traders try to exploit. Some of the most effective strategies exploiting this phenomenon include:
Mean reversion with moving average
The moving average represents the price mean, so the aim is to find a price level away from the average that is oversold or overbought and trade the move back to the moving average. The first step in this trading strategy is to identify a price level that is lower than the moving average, which represents an oversold market.
Experimenting with different moving averages and levels is required to arrive at a reliable level. When the price falls below the specified level, it indicates that the market has been oversold, and you should consider looking for long opportunities. One of the reversal candlestick patterns, such as the hammer, could be used to trigger your entry. When the price reaches the moving average, you exit the trade and profit.
Mean reversion with RSI
With this strategy, trading opportunities are identified using a 2-day relative strength index (RSI) and a 200-day moving average. Here is how it works: The market must be in an uptrend, as indicated by the price trading above the 200-day moving average. You go long when the RSI for the 2-day time frame falls below 10, indicating that the market has reached an oversold condition. You take profit when the 2-day RSI rises above 60.
Mean reversion with Bollinger Bands
The Bollinger Bands indicator calculates the average price and the level at which the asset has been oversold. The Bollinger Bands indicator consists of three lines: a 20-period moving average line in the middle, a lower band, and an upper band, each located two standard deviations away from the middle band.
Prices that are lower than the lower band indicate an oversold market, while prices that are higher than the upper band indicate an overbought market. You go long when the price falls below the lower band, indicating a possible buying opportunity. Close your position as soon as the price rises above the middle band.
Mean reversion with price action
This is also known as the double seven strategy, and it is used in an uptrend — when the price is trading above the 200-day moving average. Here’s how it works: When the price closes at a new seven-day low for the period, the market is oversold. So, you can go long there and then close your position when the price reaches a new seven-day high.
Trend-following strategies are based on the idea that when an asset is in a trend, it is likely to remain in that direction for a while. Traders use these strategies to profit from long-term, medium-term, or short-term trends that occur in the stock market indexes. Trend followers do not attempt to forecast or predict specific price levels; instead, they concentrate solely on identifying and capitalizing on trends.
One interesting thing about trend-following strategies is that they are not always highly correlated with one another since the trend are identified with different methods and on different timeframes. Moving averages, channel breakouts, and trendlines are just a few methods to determine the market’s general direction to generate a trade signal.
Some examples of trend strategies are as follows:
- ATR Channel Breakout strategy: This is a volatility-based breakout system. The 350-day moving average of closing prices is increased by three ATRs and added by seven ATRs before being subjected to a moving average adjustment of seven ATRs. Here’s how it works: A long position is initiated on the open of the day following an above-the-channel close, and a short position is initiated on the open of the day following a below-the-channel close. The position is considered closed when it falls below the 350-day moving average (or rises above it if it is short).
- Bollinger Channel Breakout strategy: A Bollinger Band channel is formed when a band of 2.5 standard deviations is added to a moving average of 350 days. When the market opens, a long trade is entered if the previous day’s close is higher than the highest point of the channel. A short trade is entered if the price at the close is lower than the bottom band. This is the polar opposite of what a mean-reversion strategy would accomplish. Positions are considered closed when they reach the moving average.
- Donchian Trend strategy: The Donchian trend system is divided into two parts: The trend filter requires that the moving average of the last 25 days be greater than the moving average of the previous 350 days. If the trend is bullish and the previous day’s closing price establishes a new 20-day high, a long position is opened at the start of the next trading day (vice versa, for short). This system employs the 2 ATR stop.
- Dual Moving Average strategy: The system employs two moving averages: a moving average for the last 100 days and a moving average for the last 350 days. A long position should be taken when the shorter moving average is higher than the longer moving average, and vice versa for a short position.
- Triple Moving Average strategy: This strategy employs three different moving averages: 150, 250, and 350-day moving averages. The 350-day moving average is used as a trend filter: a trade will occur only when the 150-day and 250-day moving averages are on the same side as the 350-day average. Long trades are permitted if both of them are higher. When both prices are falling, only short trades are permitted.
Pros and cons of stock market index trading strategies
- The stock market index provides investors with an already diversified stock portfolio.
- Investing in indexes is a relatively simple process compared to building your portfolio.
- Index funds are made up of hundreds of stocks, each of which is extremely difficult to replicate individually.
- Depending on how an index is weighted, some individual stock components may have undue effects on the value of the index
- The price movements can be difficult to predict as many stocks are involved and anything that affects the components would affect it.
- Indexes may be more volatile than individual stocks
How do you trade with the market index?
There are different ways to gain exposure to a stock market index, and they include index futures, index exchange-traded funds, and CFDs.
These are futures contracts whose underlying asset is a stock market index. There are futures contracts for almost every stock market index, and the contracts come in various sizes. For example, the Chicago Merchantile Exchange (CME) offers three contract sizes for the S&P 500 Index futures — the full standard contract ($250 x Index value), e-mini contract ($50 x Index value), and micro e-mini contract ($5 x Index value).
Index futures are typically preferred over other derivatives by big traders with both short-term and long-term perspectives. Some institutional traders use it to hedge their position in the equity market. To trade an index future, you need to open an account with a futures broker which offers you access to the exchange where the contract is traded.
Exchange-traded funds (Index ETFs)
Aside from index futures, you can also trade a stock market index via an ETF that tracks the index you want to trade. An ETF is an investment fund that trades on a stock exchange like a stock. When an ETF tracks a stock market index, it is known as an index ETF. There are many index ETFs from different issuers.
For example, some of the index ETFs that track the S&P 500 Index include the SPDR S&P 500 ETF (SPY), iShares Core S&P 500 ETF (IVV), and Vanguard S&P 500 ETF (VOO). To trade any of these ETFs, you have to open a brokerage account with a stock broker and trade it as you would trade a stock.
A CFD means a contract for difference, which is an agreement between a trader and a CFD broker to exchange the difference in the price of an underlying asset between the time a trade is opened and the time it is closed. There are many online CFD brokers that offer CFDs on different stock market indexes.
You can use CFDs to speculate on the value of an index. To trade a CFD on any index, open an account with a CFD broker, such as IG or IC Markets, and trade the contract of the index you want.
Is index trading possible?
The index cannot be traded directly; however, you can trade ETFs, futures, or CFDs that track the index. Please note that trading CFDs carry a higher level of risk because you depend on the CFD broker honoring the contract without a conflict of interest. Only trade with a CFD broker that is licensed by a tier-1 financial regulator.
Which index moves the most?
The volatility in different indexes varies from day to day. But on average, the index that moves the most in the US market is Russell 2000, followed by NASDAQ 100. In the European region, Germany’s DAX 30 moves the most.
Where does it come from?
Russell 2000 Index is a U.S. stock market index that makes up the smallest 2,000 stocks in the Russell 3000 Index. The index was started by the Frank Russell Company in 1984 but is currently maintained by FTSE Russell, a subsidiary of the London Stock Exchange Group.
Stock market index trading strategies backtest
A backtest with specific trading rules and settings is coming shortly.