While some traders prefer to base their binary options trading decisions on individual stocks, others opt to trade indices – and there are several good reasons for this. Stock market indices are essentially compilations of stocks that are constructed such that they track a particular market or sector. For instance, the NASDAQ 100 Index – or NDX – is a stock market index that tracks 100 of the largest non-financial companies that are traded on the NASDAQ.
What is an Index and how does it move?
An index is a compilation of stocks and is what is referred to when traders talk of the ‘Dow Jones’, ‘FTSE’ or ‘NASDAQ’. These are some of the largest indices in the world and they are made up of the largest tradeable stocks in that country or sector. The performance of an indice is measure in ‘points’ and this is what is referred to when traders discuss the Dow Jones moving 96 points higher for example. For binary options traders it is important to know that the movement higher or lower of an index is based on the many individual performances of the stocks of which it is comprised. When the individual stock prices rise, the value of the index rises and it gains points, conversely, when stocks fall the index also loses value.
The stocks that are tracked in an index are all grouped together so that when an investor purchases shares in the index in the traditional manner, he or she will actually be trading shares in all of the different companies that are compiled in that particular index.
Binary option contracts on indices will typically have what is referred to as an “all or nothing” payout, depending upon the settlement price of the underlying broad based index that is relative to the strike price of binary option.
For example, similar to with other types of trades in this market, a binary call options will payout either a fixed cash settlement amount, provided that the underlying index settles either at or higher than the strike price at the options expiry. Conversely, should the underlying index settle below the binary call option’s strike price at expiry, the contract will pay nothing to the trader.
The Benefits of Trading Indices versus Individual Stocks
While traders have numerous choices when it comes to individual stocks, there are many benefits that traders will have when they invest in an index. First, the investor is able to gain exposure to all of the companies that are in the index, yet without the need to buy into each individual company. This can save investors a considerable amount of money, while still allowing them a great deal of diversity. This also holds true when traders invest in commodities, as it is much easier – and less costly – to purchase an index versus buying barrels of oil, bags of wheat, or cattle.
Another advantage of trading indices with binary options is that all indices throughout the world are linked between timezones. This means that the performance of the Eastern stock indices can impact the opening performance of the Western stock indices. This creates excellent opportunities for binary options traders who, with a bit of research on the overnight global market performance, can look for positions which will compliment this. An additional banefit of trading indices is that they are available 24 hours per day. Following the sun around the globe, indices offer round-the-clock opportunities for making profits.
One of the other key benefits to keep in mind when trading indices versus stocks comes in how the two are priced. For example, the price of an individual stock tends to move up or down based upon news in the press or competitive activity in a particular market. This means that the trader will be “putting all of his or her eggs in one basket,” and will be at the mercy of just one company’s share movements.
Conversely, as an index represents a combination of stocks (or other financial vehicles), the value of the index is calculated based upon the price of an average of all the entities in the group.
When indices are considered to be “weighted,” this refers to how the shares in the overall index are weighted in terms of distribution. For instance, an index that is price weighted will have differing amounts of shares for each of the stocks that are included based upon price. In this case, a stock that has a share price of $5 will have one share versus a stock that trades for $1 that would have five shares in the index in order to keep the even weighting.
Indices can also be weighted based on market capitalization. This means that the stock shares that are included in the index are based upon the market value of the underlying company’s shares. Other types of index weighting can include fundamentally-weighted, as well as revenue-weighted.
Other Considerations When Trading Indices Through Binary Options
When trading indices via binary options, there are some important tips to keep in mind. First, it is important to know how many components make up the index. For example, some indices are made up of only 25 or 30 components, while others can be made up of 500 or more. This can make quite a difference.
A trader should also have a good understanding of the type of industry and/or economy in which the index is made up. In this case, is the industry or economy struggling or is it booming with positive economic news and activity?