Are Stock Indices the Solution for Moderate Risk?

Stock indices, such as the FTSE 100 in the UK and the S&P 500 (as well as the Dow Jones Industrial Average) in the US, are an important part of the financial market and are frequently mentioned in the evening news and on major financial networks.

However, a stock index is nothing more than a statistic, a value that, in the case of the S&P 500, for example, represents 500 of the largest companies (individual stocks, such as Amazon and Apple) listed in the US.

Stock indices are calculated using different formulas, including the market capitalization weighting method and the price weighting method. It is also important to understand that a stock market index, at the cash price, cannot be traded directly.

However, index trading (or trading on indices) can be done through derivatives, products that track the underlying cash price. Futures contracts, for example, track underlying assets and represent an agreement to buy/sell a specific asset at a predetermined price on a specific date in the future.

Trading financial instruments (global markets such as Forex [currency pairs], Cryptocurrencies, Individual Stocks [CFD-s on stocks], Commodities and Stock Indices [CFD-s on indices]) through a CFD provider allows clients to trade futures contracts through CFDs (contracts for difference).

CFD-s work by replicating the trading of the futures contract on the exchange, providing traders with a cost-effective way to enter the markets (CFD providers add a small spread as a commission).

The cash prices on stock indices offered by CFD brokers, which can be traded because they are based on CFD contracts, represent the broker's products, their own index. Thus, you will notice that CFD stock indices are traded under different names, such as US 500 or UK 100. Theoretically, CFD providers take the futures contract and adjust the price to match the underlying cash index (which, as we already know, is not tradable). This is because small traders tend to trade CFDs rather than the original futures contracts.

Figure 1.A - H4 Chart of the S&P 500 provided by Trading View

Supply and demand zones are regularly used in the short-term trading community. Like trend line studies, supply and demand fall into the category of price action trading. In fact, these two converging concepts on charts can highlight a particularly strong confluence.

Supply and demand zones tend to work best when they form decision points. For example, using the H4 chart of the S&P 500 again (Figure 1.B), we can see a new, albeit relatively small, demand zone formed before breaking the July 23 high of $3,293.8. This indicates that the demand zone generated enough buying force or pressure to clear the previous structure, highlighting strength.

While the article has so far used H4 charts, which are commonly used by swing traders, the examples presented can be applied to ANY timeframe, making them suitable for all trading styles, including short-term trading. This is one of the major advantages of technical analysis: its flexibility.

Technical Indicators

Technical trading indicators are common tools used to analyze short-term price movements. Some of the most commonly used technical indicators include the Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), Bollinger Bands, and Moving Averages.

While detailing each indicator in detail is beyond the scope of this article, moving averages have proven to be effective over time and are important to understand.

Largely used to interpret trends by smoothing out short-term fluctuations, a moving average is essentially a value that represents a net of previous values. For example, a 50-day moving average is a value based on the last 50 price points, usually the daily close.

Moving averages can be used on any timeframe. The most popular settings are 5, 10, 20, 50, 100, and 200. The periods highlighted in bold are typically used by short-term traders to gauge a short-term trend. The 50 and 100 period settings help to assess the medium-term trend, while the 200-day setting is often used by long-term trend followers and is a key value on most financial networks. Most technical players look for a CLOSE above/below the 200-day moving average to indicate the position of a stock index: bullish (upward) if above and bearish (downward) if below, as shown in Figure 1.C, the daily chart of the S&P 500.

Another popular way to use the 200-day moving average is through "Golden Cross" and "Death Cross" strategies. This involves a 200-day moving average and a 50-day moving average. The 50-day moving average crossing above the 200-day moving average indicates a possible bullish market and is called a Golden Cross. However, when the 50-day moving average crosses below the 200-day moving average, it is ominously called a Death Cross, indicating the possibility of a downtrend (see Figure 1.D).

While the 200-day moving average is largely used by long-term traders, short-term traders frequently examine its position to stay in line with the overall trend.

Figure 1.D - Daily Chart of the S&P 500 provided by Trading View

Like long-term traders, day traders use moving averages in a similar way, only on shorter timeframes.

As illustrated in Figure 1.E, a 30-period moving average is applied to the M15 chart of the S&P 500. It is evident that fluctuations are more pronounced on shorter timeframes. Shorter timeframes can become particularly choppy for day traders around the moving average (yellow boxes), however, as can be seen in Figure 1.E, there are healthy signals (red arrows) where the price action signals a short-term trend change.

Figure 1.E - M15 Chart of the S&P 500 provided by Trading View

Another popular method used by day traders (and long-term traders) in conjunction with moving averages is to use them as dynamic support and resistance levels.

As shown in Figure 1.F, on the M15 chart of the S&P 500, the price action bounces off the 30-period moving average (yellow boxes) multiple times.

This article has only scratched the surface of the ways in which a day trader can engage technically with the stock market index.

Breakout trading, trend trading (trends form on all timeframes), range trading, and reversal trading are the most common trading approaches used to seek trading opportunities.

Breakout trading involves waiting for a support or resistance level to be broken and then trying to trade the direction of the break. This can also lead to the formation of an intraday trend.

Trend trading on all timeframes is popular. Catching a trend at the right point, using a moving average for example, can bring incredible rewards.

Range trading involves waiting for a consolidation to form, with defined support and resistance levels that can be faded.

Reversal trading involves locating points on the chart where a reversal may occur, such as support and resistance.

No matter which trading approach you use to trade indices, make sure you trade with a defined trading plan. This is formed through rigorous back testing and forward testing on demo accounts and small live accounts.