Equity index trading allows investors to take a broad view on stock prices, without taking risk on the performance of individual shares. There are a wide range of indices, which cover stocks in many sectors as well as countries. There are many ways you can use indices to express a view, but you can also use an index to hedge your exposure.
Equities represent riskier assets that are baskets of individual shares of stocks. Equities are riskier than bonds and cash, and are generally more volatile. One of the benefits of trading an equity index is that the investment instrument is less volatile than an individual stock. In theory, when you purchase a basket of stocks as opposed to an individual stock, you are diversified, as not all the stock in the index will move higher or lower at the same time.
Equity indices generally track a major index in a country. For example, the S&P 500 index follows 500 large cap stocks in the United States. The DAX follows large cap stocks in Germany, while the FTSE 100 covers large cap stocks in the United Kingdom. When you purchase or sell short these indices you are taking a view on how riskier assets will perform in these countries.
Many investors will use an index to hedge their stock exposure. Hedging is the process of mitigating the risk you have in your portfolio. If you are concerned that stock prices will decline, but you do not want to exit your individual stock positions, you can consider hedging your equity exposure by using an index. For example, say you have a portfolio of 25 shares of U.S. large cap stocks. Ahead of a monetary policy decision you decide that you want to hedge your exposure in case the Federal Reserve surprises the markets with a change in policy. To hedge your exposure, you would short sell either a portion of all of your notional value. To do this you would calculate the dollar amount of stock you hold and then short sell that amount using an index. In this case you would use the S&P 500 index. If most of your stocks were technology shares, you could use the Nasdaq 100. If your shares are British stocks you could sell the FTSE 100.
Most investors speculate on the direction of an index, and either use fundamental or technical analysis to determine the future direction of an index. The fundamental analysis that most investors use to determine the future direction of an index is macro in nature. Instead of looking at earnings of the stocks that make up the index, you would focus on economic growth. Generally, stocks tend to perform well when an economy is growing and interest rates are low. As, central banks begin to tighten rates, it becomes more difficult for stock prices to rise.
Another form of speculation is a long versus short position. Here you might buy one index and simultaneously sell another index. Your bet in this instance would be that one index would outperform another index.