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Index trading has become popular among traders looking to escape individual company risk, or to hedge a portfolio of stocks against adverse market movements.
Shaun Murison, senior market analyst at IG Markets South Africa, is on hand to guide us through the intricacies of index trading.
What is an index?
It is a basket of stocks, usually weighted by market cap. 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 a Contract for Difference or CFD. Effectively, what you are buying is the price movement in the index.
What are some of the more popular indices used by traders?
The most popular is the Nasdaq, primarily because it has fairly good volatility. The Nasdaq is the preferred exchange for tech stocks, and these tend to move quite aggressively, which is something traders like.
The other popular indices used by traders are the German Dax, FTSE 100, the Dow, the S&P 500 and of course the FTSE/JSE Top 40 Index. We have different names for these indices.
|Index name||IG Markets equivalent|
|Nasdaq||US Tech 100|
|FTSE 100||FTSE 100|
|S&P 500||US 500|
|FTSE/JSE Top 40||SA 40|
We also have theme-based indices such a cannabis index (based on the top listed cannabis stocks), a FAANG index (made up of Facebook, Apple, Amazon, Netflix and Google/Alphabet), and an emerging market index, to name a few.
What are your three top reasons for adding index trading to your investment arsenal?
Actually, I have four.
It’s a way to avoid individual company risk. Because you are buying an index which is an average price made up of several underlying components, you get the benefit of diversification. If you were to buy the underlying stocks individually, it would be far too unwieldy for the average investor, and way too costly.
You can go long or short, so you can trade the market in either direction. This is what traders love, and for those with equity portfolios, shorting the index which best matches your portfolio composition is a way to hedge your portfolio.
You have a variety of indices to choose from, and the costs are low compared with share trading. At IG Markets we do not charge commissions, so traders only pay the ‘spread’ costs. The spread is the difference in price paid by buyers and sellers of a financial instrument and is how brokers make money. The spread tends to be very small, but varies according to market liquidity. In other words, the more people trading the index, the lower the likely cost. It’s certainly considerably cheaper than a direct purchase of shares.
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 great when you correctly call the direction of the trade, but you have to be careful to exit a trade quickly when it goes against you.
How do I know what I am buying when I trade an index?
The components of every index and their weighting in the index are subject to constant change.
The table below shows the top 10 components of the FTSE/JSE Top 40 index as of February. You can see BHP and Richemont are the largest constituents with a bit over 13% weighting each. At one time Naspers accounted for 25% of the index, so you would want to have a fairly positive view on Naspers if you wanted to buy the index. Today, Naspers accounts for just 5% of the index. You will also notice that the main constituents are largely commodity or foreign exchange earning companies, so it represents a strong hedge against a weak rand.
Is index trading for everyone?
Probably not. It would be suitable for those taking a shorter-term view of market movements, and as such should probably not comprise more than about 25% of your total portfolio. It certainly can be used very effectively to insure your equity portfolio against an adverse move. For those who like volatility, index trading can be a useful addition to your toolkit.
Is index trading riskier than buying shares directly?
No, because the index spreads your investment over multiple share positions so you get the benefit of diversification. This makes the index less volatile than a direct exposure to shares, but bear in mind that index trading does carry a higher degree of leverage – so that can increase the risk. Your profits will be amplified if you call the direction of the market move correctly, but your losses will also be amplified if you get it wrong. So you need to invest with correct position sizes, and tape 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 over-the-counter derivative provider and an authorised financial services provider (FSP No 41393). It has an office in Sandton to service its thousands of South African clients. Its board and senior management in South Africa consist of largely South Africans, making it a truly South African operation. As one of the biggest employers in the online broking category, it is proud to be playing a leading role in the growing financial services industry in South Africa.
Note that CFD losses can exceed your deposits.
IG Markets is part of the LSE-listed IG Group, which has a market cap of £3.4 billion (R71.4 billion). It has more than 330 000 active clients worldwide.
Brought to you by IG Markets South Africa.
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