Module 8: Basic Indices Trading Strategies

8.1 Introduction to basic trading strategies ^[1]

A trading strategy refers to a specific set of actions taken when buying or selling in the securities market. These actions are based on predefined rules, and performed with a target outcome in mind. 

Trading strategies can range from simple to complex, depending on factors such as objectives, time horizon, tools available, risk tolerance and experience level. The point of trading strategies is to have a framework to guide your trading decisions and activities. Hence, it should be based on objective data and adhered to diligently.

Having said that, traders should be willing to alter their trading strategies in accordance to changes in market conditions and/or personal objectives. 

In index trading, a trading strategy revolves around fundamental factors such as geopolitical events, economic news and market developments. Paying attention to macro factors with the potential to impact stock markets is an essential habit to build when trading indices. 

Technical analysis can also be helpful for those pursuing more advanced trading strategies, some of which we will be discussing in this module. 

8.2 Sector rotation strategy ^[2]

A stock market is made up of several different sectors, such as energy, healthcare, consumer products, finance, etc. Each sector progresses through their own business and economic cycles, which means they have their own high and low periods. 

Thus, a sector rotation strategy involves identifying the business cycles of different sectors and making trades to benefit from them. Specifically, an investor would buy into companies that are slated to experience an upswing according to their business cycle. 

Once the cycle reaches its peak, the investor should prepare to sell off their holdings and buy into the next sector that is coming up – in this way, rotating between sectors as appropriate.

When applied to indies trading, care should be taken to select the appropriate index that focuses on the sector you want to rotate into. 

For instance, if you’re looking to rotate into the technology sector next, your aims will be better served with the Nasdaq 100, rather than, say, the DJIA. This is because the former is much more concentrated on tech stocks, while the latter is more spread out among different sectors. 

Taking the idea one step further, if you believe that venture capital firms are on the prowl for the next big tech innovation, you may want to pay attention to indices that track small-cap tech companies, such as the S&P SmallCap 600 Capped Information Technology. ^[3]

Pros and cons of sector rotation strategy 

Theoretically, a sector rotation strategy can allow investors to sidestep market downturns and continue benefiting from the natural ebb and flow of business cycles. It can also be fairly predictable, with lesser uncertainty than other trading strategies.

However, to be successful in sector rotation, a trader needs to have a keen understanding of the relationship between different sectors and the ability to discern when business cycles are starting or ending. 

Also, previously established cyclical patterns may face disruption from unexpected events or novel developments, leading to delays or unfavourable outcomes. 

8.3 Trend trading strategy ^[4]

In trading, a trend is defined as a general direction the market is taking during a particular time frame. 

Trend trading, then, is a strategy that attempts to predict an upcoming market trend; this is based on the idea that what has happened in the past provides clues as to what could happen in the future. This isn’t about magically predicting the future; rather it’s all about reading the signs on a price chart.

As a simple example, consider how a trader may take a long position during an uptrend – which may be observed when there are higher highs and higher lows. When the trend reverses and starts entering a downtrend – characterised by lower highs and lower lows – a trader may then close his long position and open a short one instead.

Because trend trading hinges on price action, various technical analysis tools can be useful. Some of these include trendlines, momentum indicators like the Relative Strength Index, and the moving averages. 

Pros and cons of trend trading strategy 

Trend trading strategy can be beneficial as it helps identify buying and selling opportunities, improves decision-making, and minimises risks. It can also provide a deep understanding of the market, as there are various data points – financial statements, economic indicators, and market data – and several methods used in analysing trends. 

However, bear in mind that a trend trading strategy relies on having access to accurate data. Incomplete or otherwise flawed data can lead to inaccurate or misleading analysis.

Another criticism of trend trading is that historical data can only provide a limited perspective on the future. Investors should also make allowance for unexpected changes in the markets or disruptions to previously held notions. 

8.4 Position trading strategy ^[5]

Position trading strategy involves holding a trade position over a relatively long period of time, from several weeks to months. This is based on the expectation that the index held will appreciate in value, especially during a temporary downturn in which an index is reading below average values. 

An offshoot of trend trading, position trading shares the same core belief – that once a trend starts, it is likely to continue for some time. Hence, a position trader spends time identifying a trend, buys into it and waits to sell when a peak is reached. 

While the idea may appear similar to buy-and-hold strategy, a position trading strategy typically holds positions over a comparatively shorter duration. In contrast, buy-and-hold is a passive investing strategy whereby an investor adds to their portfolio by progressively buying securities for their long-term appreciation potential. 

Pros and cons of position trading strategy 

Position trading can be relatively simple, as once the trend is identified and the trade is set up, all that is left to do is to wait for the index to climb up. Trading frequency is also lower, which means more savings on trading fees and commissions. 

The disadvantage is the longer duration required; you may have to wait a significant amount of time before the index reaches your target level. This also means capital is tied up, leading to potential opportunity costs. 

Another drawback is the risk of getting caught in a trend reversal is heightened, as position traders may choose to ignore minor fluctuations to a greater degree than other types of traders. Proper use of stop-losses and risk management should be highlighted. 

8.5 Breakout trading strategy ^[6]

More technically minded traders may prefer to follow a breakout trading strategy. Similar to trend trading, a breakout trading strategy looks for a breakout in an index, and places an appropriate trade in response. 

A breakout is defined as an index price moving out of a defined support or resistance level – accompanied by increased volume. Once the index rises beyond the price barrier, there is usually increased volatility, and its reading tends to follow in the direction of the breakout. 

Accordingly, when a trader identifies a breakout above resistance, they would open a long trade; if the index breaks out below support, they would take a short position. 

Pros and cons of breakout trading

Breakout trading can be applied whether you’re using long- or short-term strategies, as the concept behind it is universal. Hence, one of breakout trading’s key benefits is its versatility. Another advantage of the breakout trading strategy is the potential to profit from quick market moves, as breakouts can be identified and exploited even in very short timeframes.

In terms of drawbacks, breakout trading requires patience, as you would need to watch for confirmation whenever the index being traded moves beyond the support or resistance line. You would also need to look for a suitable index – i.e., one has established strong support and resistance levels, and keep watch for when breakouts occur. 

Also, while deciding on an entry point is relatively straightforward, picking a suitable exit point can be less so, and allowing a failed trade to run on can accumulate losses.  

8.6 Swing trading strategy ^[7]

In a swing trading strategy, the goal is to profit from the many price swings that naturally occur within a larger trend. It is considered a form of day trading, as trades taken are usually short-lived, lasting from a few hours to several days. However, swing traders may also hold positions over months, if the underlying index has the temperament for a longer duration. 

In swing trading, the key is to look for points where an index is expected to make a move up or down, and then opening a respective long or short trade. If the expected price movement materialises, the trader stands to capture the resulting profit. 

Unlike a trend trader, swing traders ignore the larger trend of the index, focusing instead on the price swings within a trend. As long as there is a large enough swing, a swing trader may decide to go ahead with a trade. 

Pros and cons of swing trading

Swing trading can be applied to a large variety of indices, whether volatile or tame. It can be performed with shorter trades, increasing the potential for faster returns. 

If successful in capturing the bulk of market swings, a swing trader can realise significant profits regardless of market direction. Swing trading is also comparatively simple, primarily relying on technical analysis.

On the flipside, swing trading requires good technical analysis skills – something that not every trader has the interest to hone. Abrupt market reversals can often catch swing traders off-guard, resulting in substantial losses. Also, by focusing on short-term swings, swing traders may miss out on opportunities in larger market trends. 

8.7 Backtesting and practice ^[8]

While index trading strategies may be based on relatively straightforward concepts, they can be difficult to grasp until you see them in action. Yet, as not everyone has the funds to waste on costly mistakes (and neither should they), the next best thing to build practical experience of trading strategies is via backtesting and practice.

Backtesting means putting your trades to the test using historical market data. After forming an idea for a trade and selecting the appropriate trading strategy, you run the trade and see how it would play out retrospectively. Many popular trading platforms such as MT4 offer robust backtesting capabilities.

The idea here is that if a trading strategy does well on historical data, it is also likely to do well in current and future market conditions. If the strategy does not return good results from backtesting, then the possibility of an unfavourable outcome in a live market is heightened, and traders should make the necessary adjustments.

However, no matter how well a particular trading strategy performs in backtesting, it does not guarantee success when applied to the real world. Still, it is an invaluable tool that helps you to understand and refine your trades without risking any capital.

Backtesting vs paper trading

Note that backtesting is distinct from paper trading due to the forms of data used. 

Backtesting relies on historical data to test the viability and risk level of your selected trading strategy. Meanwhile, paper trading allows you to apply a trade to live market data and track its performance in real time without putting in any actual capital. To try out paper trading, you’ll need a demo account. 

Backtesting has the advantage of running several tests in quick succession, tweaking and adjusting different parameters as you go to refine your trading strategy. In paper trading, you have to wait for your trade to play out in real time. 

In both backtesting and paper trading, any resulting profits or losses are on paper only, and no changes will be made to your cash trading account. 

Module recap

• A trading strategy is a set of actions made when trading indices, based on predefined rules, and performed with a target outcome in mind. 
• The point of a trading strategy is to provide a structured framework for your trading decisions.
• Trading strategies can be simple or complex, and consider factors such as objectives, time horizon, tools available, risk tolerance and experience level.
• A sector rotation trading strategy attempts to profit from the cyclical nature of certain sectors. A trader would buy into a sector that is slated for an upswing according to its business cycle, and sell at the peak of the cycle. 
• Sector rotation strategy can allow a trader to avoid larger market downturns. It can be a fairly predictable strategy, with lesser uncertainty. However, sector rotation strategy can break down when unexpected events disrupt natural business cycles. 
• A trend trading strategy focuses on identifying and trading emerging trends on a price chart. It is based on the idea that what has happened in the past provides clues as to what could happen in the future.
• Trend trading can help to identify trading opportunities and minimise risk. As analysing a market trend can involve several data points, investors using trend trading can establish a deep understanding of the market. 
• It’s important to bear in mind that historical data can only offer a limited insight into future events, and allowances should be made for unexpected occurrences. 
• Position trading involves holding a position over a relatively long period of time, on the expectation that the index will appreciate in value. 
• The advantages of position trading is that it is a relatively simple strategy, and requires a lesser number of trades to be made. The disadvantages are longer duration of trade, and potential opportunity cost of tying up capital. There is also greater risk of getting caught in a trend reversal since position traders often ignore minor fluctuations.
• In breakout trading strategy, a trader looks for a breakout in an index, and places an appropriate trade in response. Breakouts are when an index’s price moves above or below a strong line of resistance or support, accompanied by a clear increase in volume. 
• Breakout trading is highly versatile, applicable to long or short timeframes. However, success requires the ability to find an index with established resistance and support, and the patience to watch for confirmation so as to discern between true breakouts and false ones (fakeouts).
• In a swing trading strategy, traders attempt to capture profit from the price swings along a larger trend. Swing trades tend to be short-term in nature, and relies upon  identifying points where an index is expected to make a move up or down, and then opening a respective long or short trade.
• Swing trading can be applied to indices that are volatile or tame. Overall trends are ignored in favour of smaller price swings, and successfully capturing the bulk of swings can let a trader realise significant returns no matter where the index heads. However, because of this, swing traders can often miss out on opportunities found in larger market trends.  
• Backtesting is the testing and refinement of trading strategies using historical data. If a strategy produces good results in past markets, it is also likely to perform well in current or future market conditions. 
• Backtesting is not to be confused with paper trading. The former uses historical data, while the latter uses live market data in real time. 
• Both backtesting and paper trading allow you to make trades without committing any capital. 

References

1. “What Is a Trading Strategy? How to Develop One – Investopedia”. https://www.investopedia.com/terms/t/trading-strategy.asp. Accessed 18 April 2024.
2. “ETFs For Sector Rotation Strategies – Investopedia”. https://www.investopedia.com/articles/exchangetradedfunds/08/sector-rotation.asp. Accessed 18 April 2024.
3. “S&P SmallCap 600 Capped Information Technology – S&P Dow Jones Indices”. https://www.spglobal.com/spdji/en/indices/equity/sp-smallcap-600-capped-information-technology-sector/#overview. Accessed 18 April 2024.
4. “Understanding Trend Analysis and Trend Trading Strategies – Investopedia”. https://www.investopedia.com/terms/t/trendanalysis.asp. Accessed 18 April 2024.
5. “Position Trader Definition, Strategies, Pros And Cons – Investopedia”. https://www.investopedia.com/terms/p/positiontrader.asp. Accessed 18 April 2024.
6. “The Anatomy of Trading Breakouts – Investopedia”. https://www.investopedia.com/articles/trading/08/trading-breakouts.asp. Accessed 18 April 2024.
7. “Swing Trading: Definition and the Pros and Cons for Investors – Investopedia”. https://www.investopedia.com/terms/s/swingtrading.asp. Accessed 18 April 2024.
8. “Backtesting: Definition, How It Works, and Downsides – Investopedia”. https://www.investopedia.com/terms/b/backtesting.asp. Accessed 18 April 2024.