INDEX TRADING - WHY BOTHER?
A 24 / 5 Casino, or a Wealth Creation machine?
"Indices are a measure of a section of shares in the stock market, created by combining the value of several stocks to create one aggregate value"
I meet a lot of people on a daily basis, and I still have to pause when asked the invariable question of ‘What do you do?’. I gave up on responding with “I’m an Index Trader” a long time ago, after I was constantly met with blank stares. Much easier to say “Share Trader”….everyone seems to understand that.
So why did I move to the dark side many years ago and enter the ‘mystical’ or ‘scary’ world of index trading. The short answer is because, once you understand it, it really isn’t that scary or mystical at all. This, combined with the fact that I simply don’t have the energy, desire, or time to keep an eye across an entire breadth of individual companies, their latest financials, and going-on’s. To me that’s a massive waste of my time. I prefer to focus on doing a small number of things really well, rather than trying to do many things, poorly. This has been particularly beneficial in periods like we’ve seen over the past week.
"He who is everywhere is nowhere."
Seneca
In Australia, the most widely traded index is the Australia 200 - Cash, derived from the SPI 200 Futures contract, the benchmark equity index futures contract in Australia, which is based on the underlying S&P/ASX 200 Index. According to Wikipedia "The S&P/ASX 200 index is a market-capitalization weighted and float-adjusted stock market index of stocks listed on the Australian Securities Exchange. The index is maintained by Standard & Poor's and is considered the benchmark for Australian equity performance."
Recently with the creation of ETF’s, the popularity of holding underlying index’s has ballooned.
Advantages to holding / trading an Index:
- Under a 'Buy and Hold' strategy, an Index is a passive, low cost and simple way to gain exposure to relatively consistent positive returns on investment.
- Quarterly rebalancing ensures 'laggards' are removed, and standout performers are included in the index, enhancing the overall 'value' of the index over time all other things being equal.
- Transaction costs are low, due to the high volume of trades and competition amongst providers.
- You are not directly exposed to any 'stock-specific' risk, as you’re well diversified across companies and sectors
- Just like many well-known stock traders advocate to trading a limited number of names, as each has their own attributes and price action, so it is with Index Trading. History repeats. The historical data overwhelmingly shows that human behaviour doesn’t change during periods of panic and greed, and this can be exploited. And exploited it has been, over the past week.
I currently trade only 3 products, but I would suggest that I know them better than just about anyone else. The Aus200 Cash, UK100, and SPX500.
INTRODUCTION TO AUS200
Did you know the the ASX is the first major index to open every day, and gives us Aussie traders an enormous advantage over our offshore friends? You only have to look at the end of day moves of the UK, and US markets when our market rallies / falls 12-18 hours earlier to confirm this.
The S&P/ASX 200 is the major stock market index in Australia (often referred to as the “XJO”). It is made up of the 200 largest publicly listed companies in Australia, based on market capitalization, and therefor considered to be a good indicator of the overall performance of the Australian stock market. The index is calculated by Standard & Poor's and is maintained by the Australian Securities Exchange (ASX).
There are 2 major products traders use; the Australia 200 Cash, and the Australia 200 rolling quarterly futures contract ("SPI" calculated off the SFE SPI 200 Index). One way to think of these in practice is that the Australia 200 Cash product trades at what the 'Basket' of the top 200 shares are doing TODAY, while the quarterly rolling contract price is what institutions are predicting for the index AT THE END OF THE CONTRACT. Spreads are generally wider on the SPI, however there are no overnight holding costs (as these costs are 'built into' the discount / premium vs Australia 200 Cash.
Futures contracts, like the SPI, are financial derivatives that derive their value from an underlying asset. They are agreements to buy or sell an asset or instrument at a predetermined price in the future. They are often used for speculation or hedging, with fund managers using them to protect their portfolios during times of volatility, and speculators using them to make leveraged returns based on their sentiment towards an asset.
For example, a fund heavily exposed to ASX shares might take out ‘insurance’ by selling contracts if concerned about a near-term market crash. By selling the futures (short selling), the fund would offset losses in the shares it holds with gains from its SPI 200 futures.
On the other hand, speculators like me take advantage of the temporary mis-pricing of futures vs the underlying asset (the XJO). This happens A LOT, and the regular mis-pricing’s are very obvious when you dig into the historical data.
Overnight, the AUS200 price movements roughly track a number of market, in an effort to ‘predict’ where the XJO will open the next day.
As an example, let’s say the AUS200 falls in line with the SPX overnight (as it has done this past week), and speculators are pricing in a fall of 2% for the XJO at open the next day. Do the Top 200 companies collectively fall 2% the second the market opens? Depending on a couple of factors, sometimes. But when it’s clear that this is not the case, the futures price must quickly ‘adjust’ either lower or higher, to reflect this. Therein lies the opportunity, if you know what you’re doing.
INTRODUCTION TO THE UK100
The Financial Times Stock Exchange 100 Index, also called the FTSE 100 Index, FTSE 100, FTSE, or, informally, the "Footsie", is a share index of the 100 companies listed on the London Stock Exchange with (in principle) the highest market capitalisation.
The index is attractive from an index trading point of view due to it's volatility on open (5pm currently AEST), regularly mis-pricing market sentiment which gives traders some attractive opportunities to make large returns, often in a matter on minutes. Of course, downside risk is significant also.
There are a number of 'Tells' that we can glean from price action late in the Aus 200 trading day, and into the Aus 200 aftermarket trading which indicate likely UK open sentiment. This stems from UK financial institutions attempting to 'Front Run' ADR's and shares in our market prior to their market opening (ie buying Rio Tinto in the Aus 200 before it likely opens higher on the UK 100).
INTRODUCTION TO THE SPX500
The SPX500 / US 500 Cash is the primary index of the NYSE and tracks the top 500 companies. The physical market operates from 9am - 4pm Eastern Time (12am - 7am AEST currently). Futures continue to trade on CFD platforms outside of these times.
The SPX500 can have an effect on our market throughout the day (should the SPX futures start moving strongly during the Asian session), and particularly late in our trading day (via large parcels of physical trade orders incoming from the US). For example, Asia session falls on the SPX futures translate into an average XJO fall of 48pts. It’s worth paying attention. These moves can also be used to predict / identify any potential mis-pricing in the SPX futures prior to the US market open.
For example In the absence of any significant news or economic data, statistically it is highly unusual for the SPX futures move during the Asian session to materially misprice the direction of the upcoming NYSE session. So while the Yanks are busy sleeping, there are opportunities for us to gain an edge in trading this market if you’re patient.
WHAT’S THE BEST WAY TO TRADE THE INDEXES?
Personally I use CFD’s to trade these products, although there are other ways to get exposure to these markets, such as via options, spread betting, ETF’s etc.
In terms of brokers I have relationships with several, however currently my preferred broker due to their leverage and fixed spreads held during this volatility is Trade Nation. As always, it’s important to find the platform and broker that suits your personal needs and preference.
CONCLUSION
Of course the other major attraction in learning how to trade Indices is the ability to hedge your existing positions, or join in when markets crash like they’ve done this week. There are not many professions where you have the ability to make a month, or a year’s salary in a day, or week (after a steep and painful learning curve during the GFC, I’ve now done this twice, during Covid, and over the past week).
I do understand the attraction behind 99% of people in the industry wanting to follow the well trodden path of individual share trading. It’s exciting when a speccie Mining stock or Biotech has the potential to go from 1c to $100, and it probably makes you feel clever to sit around at the Sunday BBQ and tell your friends why you are sure Coles is being underpriced on a DCF basis. You also have many more excuses available to you when a position doesn’t work out (bad management, bad government, the market just doesn’t “get” it etc).
So is it worth learning the ropes of Index Trading? In my opinion, absolutely. I wouldn’t be able to make a living with minimal time in front of screens, and travel full time any other way. So for me, while it’s much easier to say I’m a share trader, I’ll stick to the indices.
Cheers
Marto