Advantages of Trading with Indices
Nowadays a Forex broker is more than a middleman offering access to the interbank market. Due to the CFD’s rise in popularity, brokerage houses expanded the products in a trading account in areas long-thought impossible for the retail trader.
Using the same trading account, trading the Forex market comes together with trading other markets like:
- commodities: gold, oil, palladium, platinum, silver
- shares of large international companies
- indices: major international stock market indices
- ETF’s (Exchange Traded Funds)
Pros of Trading with Indices
Indices are weighted averages that use a formula to display the combined value of the equities that make it. The number of companies in an index differs from country to country and stock exchange to stock exchange.
The most representative indices worldwide are:
- DJIA – Dow Jones Industrial Average in the United States
- S&P500 – Standard and Poors 500 in the United States
- NASDAQ in the United States
- XETRA DAX in Germany
- IBEX in Spain
- FTSE in the United Kingdom
- NIKKEI225 in Japan
- CAC40 in France
One of the major advantages of trading with indices is that traders get exposure to the overall market, and not only to one individual company. For instance, the price of an individual stock varies based on many things that depend exclusively on that company:
- changes in management
- dividend yield
- dividend date
- changes in EPS (Earnings per Share)
- launch, success or failure of new products
- the opening of new markets
- mergers and acquisitions
All these represent variables for an individual trading asset like the stock price of any particular company. One needs to understand the incoming data and the company very well before deciding to buy or short-sell the stock price.
In other words, trading comes at the end of a process destined to understand a company and not the entire market. Indices, on the other hand, offer a general, balanced view of the stock market and the economy as a whole.
For Forex traders, the stock market is an excellent source of information. Many currency pairs, especially the JPY pairs, have a direct correlation with what happens on the international stock market.
Therefore, traders closely scrutinize the stock market and how indices rise and fall to forecast the next move in the JPY pairs.
Often, traders use a Forex trading system to profit from such correlations as the one explained above. Because trading with indices offers a great opportunity to diversify the trading account, it is mandatory to know what drives the financial markets and how to position for the next move.
Indices have an indirect correlation with the interest rate level in an economy. For instance, if the central bank starts an easing cycle (i.e., lowers the interest rate level), the stocks will rise as investors are willing to take more risks in the search for higher yields. On the other hand, a tightening cycle triggers a drop in the stock market or at least a severe correction/consolidation until the monetary policy changes.