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How to trade indices

Find out how to spot trading opportunities in the indices markets


Understanding correlation between indices

Indices are either region based or sector based and serve as an excellent indicators for the prevailing market sentiment. Since, however, in our days local economies are strongly intertwined, it is no surprise that indices tend to be highly correlated.

The correlation between global economic events and the price patterns of major indices is a key understanding for traders who want to participate in the fascinating indices markets. You may, for example, know where the DAX is currently trading and whether it opened lower or with a bullish gap, but what does that mean for you as a trader and how can you capitalize on the opportunities lying behind the numbers?

How to scan the indices markets

The most important information about an index, often provided alongside its current price, is the daily change (as a percentage) and the number of points that it has moved up or down since market open.

Let’s take the DAX for example. If you think that the economic outlook for Germany is positive, you would buy DAX CFDs in the expectation that companies in Germany would pull the price of the index up.  

It is important to remember that at times indices may rise not as a result of real economic growth, but simply due to increased risk appetite to own risky assets, like shares. These deviations, however, cannot last long and a price correction is likely to follow soon. Traders often compare the performance of indices from different regions in order to spot and take advantage of opportunities. Let’s find out how that works in practice by comparing DAX and S&P500.

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Correlation between DAX & S&P500

The S&P500 index is considered a valuable barometer of the US equity market and is followed as an indicator for the strength of the major industries represented in it. On the other side of the Atlantic, the DAX mirrors the performance of the German stock market.

The chart below shows the strong correlation between the two leading indices. When DAX and S&P500 don’t move in tandem, this is often seen as a price anomaly, and often a trading opportunity.

DAX - S&P500 price correlation

Differences between DAX & S&P500

In order to evaluate how the markets will move in case of a price anomaly it is important to know the unique characteristics of each index and the region and industries it represents.

  1. Constituent companies

The US economy is a heavily consumer-driven economy with S&P500 representing IT, financials and health care up to roughly 50%. Germany, on the other hand, is an export-driven economy, with only a small technology industry. In the case of DAX, it is chemicals that have the highest weighting.

  1. Total-return vs. price-return index

Total-return indices measure the strength of their constituent companies assuming that all dividends are re-invested. DAX, for example, is a total-return index. Contrary to that, S&P500 is a price-return index, meaning dividends are not included in the calculation of the return. This is one of the reasons that helps DAX push higher compared to non-total-return indices.

When the prices of indices diverge, it is important to take into consideration the above factors before deciding which side of the market you will trade. The most popular way to trade indices is via CFDs, also known as Contracts for Difference. These financial instruments allow traders to profit both from rising and falling prices, by opening long (buy) positions, if you think an index will rise or short (sell) positions, if you think the index will fall.

Indices trading example

Going long on DAX

Let’s suppose that the DAX is currently trading at 12,427.20. Your research suggests that the market sentiment is positive towards DAX and your technical indicators give you an entry signal. You decide to buy 1 Lot. This position size equals €1 of profit or loss for every point of movement in price.

Two days after, the DAX has indeed pushed higher and it is now trading at 13,120.20. Your profit is calculated by deducting the opening price from the closing price: (13,120.20 - 12,127.20) x €1 = € 993.
Note that in the above example profit and loss is calculated in the currency of the region that the index is tied to. But no reason to worry how that translates in the currency of your trading account. At ThinkMarkets, the profit and loss is automatically converted in your currency in real-time based on the current exchange rate.

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