While most experienced investors that are already familiar with the world of trading might have heard of an index, a lot of the new investors haven’t. A common assumption is that stock indexes are traded like individual stocks.
There are a lot of such assumptions surrounding the stock index due to lack of information, but the right answer is that these exist merely for informational reasons. Even though there is data available on them, and they can be charted in the share market, making a short or long trade on the index stock itself is not possible. This is what creates the need for other financial products, such as opinion contracts and futures, which can be used to trade the movements of these stocks.
Read this article if you are a beginner and want to know how to trade in index.
What is a stock index?
A stock index is a set of stocks that are collected as samples to indicate how a particular part of the share market is performing. For instance, an IT (information technology) stock index will provide information to track IT sector stocks. The index changes in proportion to the average performance of the respective stocks. This stock index is henceforth beneficial to traders who wish to swiftly oversee the performance of those particular stocks at that instant or over a period of time.
Indices are very useful to traders as they provide an overview of multiple sets of stocks for various parts of the stock market. They are not only beneficial tools for trading but for analysis as well. As mentioned earlier, even though they can not be traded directly, there are financial instruments in place for investors to trade the movements of these stocks.
An example of a well-liked stock among traders is the S&P 500 index, as it gives access to five hundred stocks with only one option contract or futures transaction.
What are futures and option markets?
When an investor mentions that they are short or long on a particular stock index, they are not short or long on that index technically. They are short or long on the future or options market associated with that index.
These are also called derivatives markets as they are derived from the associated stock index. Their value is dependent on the movement of the stock index that it is associated with. Future and option markets are open for all well-known stock indices. Derivative markets are a popular choice for long term traders as well as short term traders.
Though these markets can be accessed by investors, they still have an expiry date. Thus, individual traders tend to use derivative markets more for swing trading or day trading.
What are derivative market strategies?
· Call option
These are contracts that provide the trader with the right to buy a stock or security at a predetermined price within a certain period of time. The security agreed upon is known as the underlying asset. This kind of buyer is able to make a profitable return when the value of the said asset goes up. This particular value is fixed and is thus called the strike price.
The buyer of the above agreement must exercise their option before the expiration date, after which the seller can rightfully sell the underlying asset at the (fixed) strike price.
However, if a buyer buys such an agreement at a price below the value of the underlying asset and then proceeds to sell the asset, they would make a profit.
· Put Option
A put option is an agreement that provides the trader with the right to sell the underlying asset at a particular price at any given instant up to the date of its expiry. This means that the buyer has bought the option to sell it. In the case that the stock price is lower than the underlying asset value and the buyer buys the option to sell as well as buy the stock, then they are in a position to make a profit as the purchase cost was less than the selling cost.
Put options can be described as being at, in, or out of the money. In the case that the underlying value is equal to the strike price, it is known as being at the money. In the case that the underlying value is below the strike price, it is known as being in the money and in the case that the underlying value is more than the strike price, it is known as being out of money.
Stock indices are a well-known trading tool for a reason, even though they cannot be traded directly. An index, simply put, is just an analysis tool or an indicator of a particular part of the stock market’s performance. Indices do not have an expiry date, even though the derivative markets do. This begs the question, what is the safest strategy to trade indices for the most profitable returns? There is no straight answer to that question as it depends on various factors. However, the best strategy is always the one that suits your financial needs and trading styles,
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