Index Trading & Shares Trading: What To Know About These Products Before Trading Them
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In the world we live in today, most financial products can be traded. Whether it’s stocks, bonds, indexes, commodities or even cryptocurrencies, we can gain exposure to these financial assets either by investing or trading them.
If we intend to trade, we can gain exposure to financial assets via Contract For Differences (CFDs). CFDs are a type of derivatives that derive their value from the performance of an underlying asset, such as equities, forex, indices, and commodities. Through CFDs, we can go long or short on the abovementioned markets without directly owning the asset.
Two popular asset classes that most of us are likely to be familiar with are indices and shares. Even if we are not actively trading these assets, we might already be investing in them.
Index Trading & Share Trading
Index trading, or indices trading, refers to the trading of indices. The performance of indices themselves is based on the price performance of a basket of securities using a standardised methodology on a stock market exchange. With index trading, we speculate whether prices would go up or down depending on our market sentiments or the technical analysis we have done.
Indices can be broad-based, such as the Dow Jones Index. They can focus on specific sectors, such as the NASDAQ 100 index that comprises primarily technology companies, or local indices like the Straits Times Index (STI). Indices can consist of equities, fixed income or commodities. By trading in an index, you are indirectly trading the entire basket of securities that are part of the index.
On the other hand, share trading refers to the trading of individual shares. When we trade these shares, we are hoping that the prices of these shares will go up when we purchase them so that they can be sold off for a quick profit.
One notable difference between trading indexes and shares is that indices tend to be less sensitive to the individual performance of a single security, because they comprise a basket of securities. These baskets of securities may reflect the performance of the entire market, such as the Straits Times Index (STI) being a proxy of the Singapore’s stock market, or a specific sector, such as REITs ETFs that reflects the performance of REITs.
While economic news, investors’ sentiments and industry outlook can affect the price of an index, specific company-related issues that will affect share prices, have less of an impact on the index.
In contrast, if we are trading individual shares, any company-related announcements or financial results can significantly impact share price. Individual companies have more unsystematic risks tagged to them, so having in-depth knowledge about the company is essential for share trading.
Ability To Go Long Or Short Via CFDs
Whether it’s indices or shares, both are securities that are available for trading and investing on an exchange such as the Singapore Exchange (SGX) or New York Stock Exchange (NYSE). However, most of us would typically buy and hold our investments on an exchange. We earn when prices of the indices or shares go up, and lose when prices go down.
With CFD trading, we have the option to potentially make profits on both direction of the market. During a bull market, we can take a long position on the index via a CFD and make money if prices go up. Conversely, we can opt for a short position during a bear market and make money if prices go down.
Can Be Used For Hedging
Share and index trading can be used not only for speculation of prices, but also for hedging reasons.
Take for example, if we invest in the S&P 500 and are worried about a market downturn in the near future, we don’t necessarily need to sell our holdings in the index. Instead, we can take up a short position on the S&P 500 through a CFD. This way, any losses that we incur on our long-term investments will be offset by a similar prospective gain from our CFD. If prices go down and we have a positive long-term outlook on the index, we can sell our CFD and use the profits to invest more in the index that has a bullish position.
The Use Of Leverage
With CFDs, many traders will employ leverage to help them increase the size of their position. Leverage allows traders to make higher profits, without using more capital.
CFDs on indices, with the world’s No.1 CFD provider like IG (by revenue excluding FX, June 2020) can provide us with a leverage of up to 20 times. This means that with just $1,000 in capital, we can take up an index position of up to $20,000. For share trading, margins provided are lower as shares are generally more volatile. Using IG, the leverage for shares is typically up to 10 times.
Index futures are derivative products used to trade stock indices at a specific date and price in the future. Traditionally, index futures could only be traded by institutional traders who buy and sell futures contracts directly by accessing the market via a broker. However, with CFDs, traders can also trade indices via Index Future.
All major indices have future contracts that are traded in the futures market. With Index Future, you can buy or sell contracts based on whether you think the underlying market prices of the future contracts will rise or fall. This can be done through CFDs with IG.
Understand The Risks Of Index Trading & Share Trading
Index trading and share trading can be a lucrative proposition for retail traders. The possibility of generating high returns within a short time, particularly during a volatile period like what we have experienced for the past 12 months, can entice people to start trading.
However, it’s important to remember that higher returns come with higher risks. If we utilise leverage in our trades, our potential losses will be magnified if share prices move against us. For example, using a 5 times leverage, a 4% decline in an index will translate to a loss of 20% if we have a long position. In extreme scenarios, if share prices gap-up or gap-down, traders may lose an amount greater than the capital they have put in.
Risk management strategies such as having a guaranteed stop-loss for each trade made is critical. Guaranteed stop-loss ensures that our position will be closed at the exact price we want, without any slippage. Alternatively, Knock-outs, which are like CFDs with an expiry and an in-built mechanism to limit the potential losses of a trader on each trade, can also be used to prevent us from losing more than the maximum amount we are willing to lose on each trade. Knock-outs can be used to trade different markets including indices and shares.
For those who are new to trading, it’s advisable that we start off with a demo trading account first. A demo account allows us to practise and familiarise with the asset classes that we are trading, and eventually refine our trading strategy before we put real money into the trades. With IG, traders can get up to S$200,000 in virtual funds to practice trading on their demo account.
With IG demo account, we enjoy free access to IG Academy, where we can learn about trading from useful online courses, live webinars and seminars. There is also an IG Community where we can discuss and learn from other like-minded traders worldwide as we explore the financial markets.
As we become more confident with trading, we can proceed to trade using a live account. It’s advisable that we start off with a small starting capital so that we don’t risk losing more than we can bear. By focusing on trading well and utilising risk management to keep our losses to a comfortable limit, we can gradually become more well-versed in trading and seizing market opportunities.
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