Top indices trading strategies

Indices trading can be perceived as more beneficial compared with the likes of FX, with historical trends highlighting why utilising a bullish indices trading strategy can prove profitable for index trading.

Trader
Source: Bloomberg

Many traders treat indices in the same manner as other classifications such as forex or commodities, opting to have little preference for one over the other.

However, there is something that clearly sets apart stock markets as an instrument type that should be treated with higher regard. That is simply the fact that stock markets have historically exhibited an innate trend, allowing traders a better idea of whether their long-term bias should lay.

There are obviously periods of weakness, yet the trend is overwhelmingly bullish for most Western stock markets. Particularly US markets. It is also worthwhile noting that during market downturns, the periods of weakness are typically shorter and sharper, while the recovery can provide a longer lasting, yet more controlled upward move. To highlight this we can look at the seasonal data from equityclock.com to highlight how stocks markets are different from FX.

Indices trading has seen substantial returns

The table below highlights the past 20 years of trading on the S&P 500. The first thing to note is that over the course of a year, the percentage return is substantially positive, cumulatively amounting to an average of 6.3% gains per year. It is also worthwhile noting that this does not include dividends which obviously add a whole secondary source of gains for stock markets. We also see the frequency of gains average at 61.25%. Finally, the type of moves seen throughout bullish and bearish periods is confirmed by the max return and min return rows. They show that, on the whole, bearish moves in stock markets are typically more powerful than bullish moves. While there is just one double-digit gaining month for the S&P 500 over the past two decades, there have been at least four sell-offs above 11% in that period.

Monthly averages over past 20 years:

Jan Feb Mar Apr May June
% Return -0.7% 0.0% 2.1% 1.8% 0.0% -0.5%
Gain Frequency 50% 55% 65% 75% 60% 55%
Max Return

5.0%

2013

7.0%

1996

9.7%

2000

9.4%

2009

5.3%

2009

5.4%

1999

Min Return

-8.6%

2009

-11.0%

2009

-6.4%

2001

-6.1%

2002

-8.2%

2010

-8.6%

2008

July Aug Sep Oct Nov Dec
% Return 0.4% -1.0% -0.8% 2.2% 1.4% 1.4%
Gain Frequency 50% 55% 50% 70% 75% 75%
Max Return

7.4%

2009

6.1%

2000

8.8%

2010

10.8%

2011

7.5%

2001

6.5%

2010

Min Return

-7.9%

2002

-14.6%

1996

-11.0%

2002

-16.8%

2008

-8.0%

2000

-6.0%

2002

Comparing those findings with that of the euro, we can see that things are very different in the forex space. Firstly, the average return over an 18-year period comes in around 1.5%; significantly short of the 6.3% (plus dividends) seen in the S&P 500. We can also see that the frequency of gains is also less appealing, with an average of around 51.9% chance that the euro will gain on any given month (well short of the 61.25% seen in the S&P 500). This highlights that forex markets often have no innate trend, unlike stock markets. Part of this is related to the fact that FX markets are pairs based, meaning that you have two alternating forces pushing and pulling any given forex pair.

Monthly averages over past 18 years:

Jan Feb Mar Apr May June
% Return -1.0% -0.1% 0.2% 1.0% -0.6% 0.6%
Gain Frequency 39% 56% 56% 61% 39% 61%
Max Return

2.9%

2013

2.3%

2014

4.6%

2016

4.6%

2011

7.0%

2009

6.2%

2002

Min Return

-8.4%

2009

-3.8%

2013

-5.1%

2001

-4.6%

2000

-7.7%

2010

-2.4%

2003

July Aug Sep Oct Nov Dec
% Return 0.1% -0.2% 0.5% -0.5% 0.0% 1.5%
Gain Frequency 44% 50% 50% 50% 56% 61%
Max Return

6.7%

2010

4.2%

2001

7.5%

2010

3.5%

2001

3.8%

2004

10.1%

2006

Min Return

-2.8%

2012

-5.9%

2008

-6.9%

2011

-9.8%

2008

-6.9%

2010

-4.6%

2009

This highlights why indices are a preferable trading instrument over the long term, especially if looking for an asset to buy and hold. In relation to a more active trading strategy, we have two pieces of information that are particularly notable. Firstly, uptrends are relatively reliable, long-lasting, and steady. Conversely, bearish market moves are typically shorter, yet more dramatic. While the attractiveness of sharper periods of weakness will attract many, the constant desire to pick market tops will typically cause traders angst with the consistency of the uptrend meaning that such a strategy can be tough to execute and too inconsistent to find enough trades. With that in mind, it makes sense to utilise the bullish nature of indices to trade with that trend rather than calling tops against the odds.

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Bullish indices trading strategies

As seen with the S&P 500 table above, stocks rise more often than they fall, meaning that a bullish longer-term trading strategy makes sense. Reinvesting dividends will add a compounding effect where your account grows proportionately bigger over time. On a spread betting account, you will also receive a dividend adjustment when the stock goes ex-dividend to counteract a drop in the share price. However, the overnight charges mean that typically long holds will be more efficient via a leveraged futures contract (which doesn’t pay dividends), a non-leveraged stock portfolio or exchange traded fund (ETF), which does.

However, for active leveraged traders, the existence of dividends is not a factor to disregard, as to a great extent this is what adds an underlying bullish trend to stock markets.

That being said, if a trader is to approach a trend-following index strategy, it makes sense to look for bullish set-ups encompassing higher highs and higher lows. Utilising that as a bullish confirmation signal, traders can employ a host of different strategies to get into the trend.

Consolidation/retracement breakout

Uptrends often do not see huge retracements, with the bullish sentiment meaning that you will typically see more small to mid-sized retracements. With that in mind, a trader can buy on the breakout into new highs, where a shallow retracement or consolidation would be utilised to place a stop below. On the Dow Jones chart below, the period of weakness seen in late September points provides a bullish buy signal at 22,429, with the prior low of 22,216 being used to place a stop below.

Deeper retracement entry strategy

The utilisation of deep Fibonacci retracements can provide traders with the opportunity to enter trades for relatively cheap compared with recent prices, reducing the size of their stop loss to raise their risk-to-reward profile. Markets do not move in a straight line, and thus it makes sense to look out for pullbacks to provide buying opportunities. However, while we do sometimes see deep retracements (61.8-76.4%), such moves often take place during times of consolidation, or volatility. The chart below highlights exactly that.

The two 76.4% retracements on the left side of the chart come off the back of a period of consolidation within an uptrend. You could take the strategy above and buy on the breakout through 23,625. Otherwise you could wait for the break through the first swing high on the way down, paving the way for a failed attempt to break into a new low. Such a move often provides deep retracements given the battle between bulls and bears. That provides us with two successful trades where you buy at the 76.4% Fibonacci retracement and place a stop below the prior swing low. The third example of a 76.4% entry comes during a period of significant volatility in early December. That volatility fails to break the overall trend of higher lows and highs, instead providing us a with a buying opportunity at the 76.4% retracement.

Bollinger entry

Bollinger bands provide another potential tool to be utilised for traders, with a return into the lower threshold of the indicator prodiving a buying opportunity. It is worthwhile noting that you can obtain greater confidence of a bullish resumption if the price either respects the band itself, or else fails to close below it when breaking below it. The example below highlights how you can tie in both Fibonacci entries with a consolidation entry. While the repeated respect of the lower Bollinger band throughout the course of this chart would have provided multiple buying opportunities, it makes sense to await a closed candle to mitigate a possible break and close below the band. Such a close would have signaled a likely impending bearish phase.

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