While stock analysis is a process of looking at each stock separately, indices trading is a process of looking at a single number that indicates the market activity of a group of stocks within a segment at one point of time. When a trader views an index, he can get an instant sense of the feelings of dozens or hundreds of businesses rather than needing to read through earnings reports and business-specific news to find out how a given business is feeling. This consolidated view makes indices a sort of shorthand for reading the mood of an entire economy or sector without having to follow every component driving that movement.
This bigger picture can be very helpful during times when individual stocks don’t seem to be following any particular pattern. It’s hard to draw anything from a move that is purely company-specific, one that could go up or down depending on factors unique to its own business. An index smooths out these individual changes over a large number of constituents to reveal whether greater economic forces are actually influencing sentiment or whether isolated stock moves are simply reflecting company specific circumstances that tell us nothing about the overall market.
Sector-specific indices add nuance to reading sentiment, allowing traders to isolate the performance of specific industries against the broader market. An independent performance by one technology sector index versus a broad market index may be indicative of a rotation of investor sentiment as money is shifting out or in of a specific industry sector based on a change in economic activity or risk appetite. This is the type of comparative analysis between sector indices and broader benchmarks that allows traders to see where sentiment is coalescing, not just whether sentiment in general is positive or negative.
Correlation between indices in different regions offers a similarly useful way to understand global sentiment, distinct from sentiment tied to one market alone. When indices from different countries or regions start to move together, it is often a reflection of bigger macro-economic forces, whether it is expectations about global interest rates, changes in commodity prices, or a broad-based risk-off move after a surprise news story. The degree to which these regional indices move together gives some context that a trader who is only looking at domestic markets may completely miss.
Indices of volatility, which measure the expected fluctuation of prices in the future but do not measure the direction of prices, add another dimension to this picture of sentiment. In many cases, an increase in volatility expectations indicates increasing uncertainty among market participants, even if the underlying index has not moved dramatically in either direction. Traders that study this in conjunction with the usual price indices get a better feel of market psychology, being able to differentiate between a calm steady trending market and one that looks steady on the surface but is building uncertainty underneath. There are considerations to trading indices that are meaningfully different from trading individual securities. Since an index is an aggregate and not a single company, sudden dramatic moves tend to be somewhat rarer than what individual stocks can experience after unexpected company specific news. This relative stability is attractive to traders who want to make a bet on the general direction of the market without the concentrated risk of any one company’s fortunes. It doesn’t, however, imply that index trading methods are necessarily long-term; rather, they tend to be more patient than, say, trading individual stocks, as the price may not fluctuate as rapidly.
This aggregation and comparison is the beauty of indices trading and why it’s really useful in gaining general market awareness. It enables traders to step beyond simple data to true pattern recognition, in multiple markets, sectors and regions simultaneously. However, traders who use index analysis can use it as part of a broader methodology, adding context to their more detailed study of the securities so that it is more useful in the broader context, but not in place of the study of the securities themselves.
