Index Trading Strategies

Everything starts with volume

I started my own trading and investing journey many, many years ago. This was long before the days of the Internet, when brokers were still using a telephone, and placing orders online was impossible. The markets were only open during the normal stock trading hours, so trading times were limited to the open and close of the physical exchange. Orders were placed by phone to your broker, who then called the floor of the exchange to execute the order, before relaying it back to you as a filled position. In a fast moving market this was extremely stressful, but nevertheless a great training ground, and perhaps most importantly it is where I first discovered the power of volume, and what we called volume price analysis, and which lies at the heart of the Hawkeye tools and indicators.

Volume is the only leading indicator, and therefore the only indicator that signals market intent. So if you can read the volume indicator, then you can read the market. It’s as simple as that, and this is where I began my trading journey. To illustrate this further let me explain the trading strategies that we used in those days, which were simply based on an analysis of the volume in two associated markets.

Futures vs cash

As I have explained on the Index trading page, an index itself cannot be traded directly since it would be impossible and unmanageable to hold a basket of stocks in the correct weightings and quantities to represent the principle index of a major exchange. Instead we have a futures contract which is based on what we call the ‘cash’ market. The ‘cash market’ is where real cash changes hands as buyers and sellers trade though the exchange for real stocks which are paid for with cash. With an index future we are not buying or selling anything but simply using this instrument to trade our view of the market. So if our indicators say that the market is rising then we buy the index future, and if it is falling then we sell the index future.

When I started I began with the UK index, buying and selling index futures on the FTSE 100, since this was a widely traded contract and therefore very liquid, and from memory I think the minimum contract value per index point was £10, with an average move in the day of maybe 100 points. So there was plenty of money to be made.

One of the questions that is often asked by novice traders is:

Which market moves first, the cash or the futures market?

The answer is always the futures market, which positions itself ahead of any move in the cash market, which moves more slowly. So this gives us our first trading strategy, and where it all began for me all those years ago. Here’s how it works.

We set up two screens, one with the cash market chart for the index, and the other with the futures equivalent. Then we watch the volume on both charts, and in particular the futures chart as this is the market that leads. So for our example suppose we see a sharp move higher in the futures market, supported by bullish volume. Then we know the move is valid and the cash market will follow, and provided we see strong bullish volume there as well, then we know this is a valid move, with buying confirmed by the market makers in the cash market. In my day, I had to interpret this all for myself by studying the volume and price action on each and every bar.

Seeing this simultaneously in the cash and the futures market is the icing on the cake, and confirms the move even more strongly. After all, no market moves higher on low or falling volume, and if the volume in the cash market is confirming the move higher, then the futures traders will have seen this move coming, and positioned themselves accordingly, ready to take advantage of the trend as the market makers move in.

This is the power of volume – it reveals whether a move is genuine, and whether the professional money is joining in or simply standing to one side. If they are buying then we buy, and if they are selling then we sell. We simply follow the money using volume as the key. This is the way I traded the index market for many years very successfully, using volume as my primary trading indicator. Understand volume and you understand how the market moves. Simply put your cash and futures charts together, wait for the volume to confirm the trend, check your other confirming indicators, and then open your position.

Intermarket spreads

A second strategy that I also used and which is extremely popular among index traders is one based on so called ‘intermarket spreads’. This is where traders try to take advantage of the relative movements between two indices, by spreading the futures. In other words going long in one market and short in the other. The most popular indices for this strategy are the S&P500, the NASDAQ 100, the Mid Cap 400 and the DJIA.

This type of strategy is relatively low risk since in effect we are hedging in the market. We need to be sure that there is a strong correlation between the two markets. The approach here is to try to identify fundamental market conditions which may affect one market more than the other. Typically these strategies are tied to the cyclical nature of stocks, which tend to follow a cycle as the economy moves from one phase to another. So for example in the early stages of an economic recovery, high tech stocks will tend to perform well, and therefore one could expect to see the Nasdaq100 perform better than an equivalent index weighted with traditional stocks.

As the recession starts to come to an end we can also expect to see small cap stocks perform well in a low interest rate environment. Though this has to be tempered with the view that this group is also sensitive to credit issues, something which has less of an issue on the big cap groups which tend to have more established lines of credit. All of this is reflected in the correlation between corporate bond and treasury yields.

So, let’s take a simple example where we are considering a spread trade between the S&P 500 and the Nasdaq 100 and look at some figures.

Suppose the E-mini S&P 500 is trading at 1300 and with a contract multiplier of $50 per point, whilst the Nasdaq100 is trading at 2400 and with a contract multiplier of $20, then the total value of each contract is as follows:

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This is approximately a ratio of 65,000/48,000 or 1:1.3 which converted to whole numbers is 3:4. This means that to place a spread trade with these contracts we should trade in the ratio of four Nasdaq100 contracts for every three E-mini contracts. The spread is then weighted correctly.

This type of trading strategy tends to be for longer term trend trading. So here you have two strategies:

  • One for intraday scalping
  • The other for longer term trading

The choice is yours and the one you choose will depend on the time you have available, your personality as a trader, and your attitude to risk and money management. There is no right or wrong strategy, just the one which is right for you.