This article is contributed to us by Kelvin Wong, Senior Market Analyst at OANDA Asia Pacific Pte. Ltd.
Country-specific benchmark stock indices are considered to be the barometer of economic growth, as they consist of stocks representing various sectors of an economy, such as financials, information technology, energy, consumer discretionary, and industrials. These sectors collectively constitute the entire economy.
Hence, the aggregate earnings growth trends of these component stocks that make up a particular stock index are likely to dictate a significant portion of the stock index’s directional movement, This movement, often, also serves as a precursor to economic growth.
Many of you may have read in financial media frequently linking the state of the US economy to the movements of major US benchmark stock indices such as the S&P 500, Nasdaq 100, and Dow Jones Industrial Average, and even on a global scale given that the US stock market is the deepest, most liquid, and has the largest market capitalization worldwide at around US$40 trillion (40% share of the global equity market) according to data from SIFMA’s 2023 Capital Markets Fact Book.
In the past two decades, technological advancements have enabled more financial intermediaries to offer trading products based on benchmark stock indices such as stock indices and contract for differences (CFDs) to retail traders on a wider scale.
In this article, we will dive straight into three key characteristics of stock indices and the factors that might influence their movements.
#1 The main advantage of trading in stock indices CFDs over individual stocks
A country-specific stock index comprises a basket of component stocks that represent the key sectors of the economy of a particular country. Thus, trading in stock indices CFDs eliminates the unsystematic firm-based risk inherent in individual stocks, offering a potential diversification benefit. By trading indices, you inherently diversify your investment, spreading risk across multiple companies. This strategy of diversification mitigate the impact of adverse events affecting individual stocks.
Moreover, it offers a mitigation strategy for the risk of delisting, where a trader may find themselves unable to exit his positions if a stock is no longer listed on the stock exchange. In contrast, major stock indices such as the US S&P 500 would have greater longevity in their lifespan.
#2 Main drivers that might impact the movements of stock indices
Other than the aggregate earnings growth trends of the component stocks of the respective stock indices, there are two other main drivers that can have a significant influence on the directional movements of stock indices.
First, while stock indices are likely to eliminate unsystematic factors, they do not eliminate systematic risks that are influenced by macroeconomic events and data. Hence, macro factors such as economic growth, inflation, monetary policies, consumer confidence, and manufacturing and services PMI will continue to have a potential impact on the longer-term trends of stock indices.
Second, on a medium to short-term trend horizon, animal spirits (aka market sentiments) play a more significant role over macro factors and that includes irrational behaviour of market participants towards the growth prospects of corporate earnings that can swing from over-optimism to over-pessimism. Hence, it is paramount for stock indices traders to have a good grasp of technical analysis to detect possible changes in the mood of the crowd.
#3 Key risks in stock indices trading
There will always be risks involved in the trading of financial instruments. The key risks for stock indices CFDs trading include overconcentration and correlation risks.
The majority of the global stock indices are constructed based on the market capitalization weights of the component stock. In certain cases, the significant growth in market capitalisation values of a few component stocks has led to their disproportionate influence on the stock index.
Most recently, the US “Mega 7”, which comprises of highly sought-after big technology firms such as Apple, Alphabet, Microsoft, and Nvidia have dictated the bulk of the Nasdaq 100 movement. Therefore, the overconcentrated influence of these technology component stocks within the Nasdaq 100 has increased unsystematic firm-based risks.
Another important aspect to note will be black swan events such as during the 2008 US subprime crisis and most recently the Covid-19 pandemic in 2020 that almost wiped out the diversification benefits inherent in stock indices as the majority of the component stocks moved in line directly with one another. Hence correlation risks increases during these two episodes of broad-based market meltdown.
Read Also: Three Things To Understand About The Market Before You Start Forex Trading
About OANDA Asia Pacific Pte. Ltd. (OAP)
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Disclaimer
Leveraged trading carries a high degree of risk and may not be suitable for everyone. Losses can exceed deposits. This article is for general information purposes and is not investment advice. It does not address the specific investment objectives, financial situation or particular needs of any person. Advice should be sought from a financial adviser regarding the suitability of any investment product before investing or adopting any investment strategies.This advertisement has not been reviewed by the Monetary Authority of Singapore.
