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Knowledge Crunch

The Indices should be our guide

Tuesday, June 22, 2021 11:21 AM GMT

Contrary to popular belief, this is not considered passive investing, rather than active portfolio management.

Why?

It contains the basic principles of adding and removing products (rebalancing) in a portfolio’s structure at a higher frequency which can be monthly or quarterly.
Passive investing is focused on multi-year positioning, mainly biased by fundamental and geopolitical analysis that might take some time to affect the index’s performance.

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So, how can we trade stocks with the help of an Index?

Choose the relevant index.
Not every Index can provide you with the right information for every stock.
There are some basic rules that we need to follow in the preselection of our lead Indices.
First of all the Index should include at least 65% of your portfolio’s stocks.
Secondly, the index must be the main one, it should be at the top of each stock exchange’s list in liquidity and transaction volume.

Concentrate on the big picture.
Trends tend to last longer in bigger timeframes.
Avoid short term decisions, there will be many whipsaws and your basic view of the market will change rapidly. It is far more efficient to use daily and weekly data to get a much clearer sentiment about the market’s direction.

Use simple technical analysis and statistical tools to compare and analyze the products versus the index.
A simple example is the one below.
We selected the S&P 500 and the Bank of America stock.
Chart’s time frame is set weekly.
With the use of two lines, we can time our entries/bias for the underlying stock.
Naturally, stocks are far more volatile than indices so timing is everything.
In the first instance, we can see that we had a rising trendline break. This could be considered as a clear technical sign that the bullish trend is over so we are checking our portfolio for stocks that belong to S&P 500 to either hedge with derivative products or even liquidate the whole position. This simple method was able to save our portfolio from a massive correction that led to new lows for the equity(!). Likewise in the next occasion, we use a resistance line of the last two peaks of the Index. This is a major level and should become violated, it would potentially signal a major uptrend.
And this is exactly what happens.
The resistance is being broken and the Index has been making new yearly highs till today.
The entry was also perfect for our chosen stock which was on its low consolidation (distribution) phase.
A perfect buy signal, which would translate either to the addition of funds to an already opened position or to include this stock in our portfolio for the first time.

Source: TradingView

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Use the index not only as a trend bias indicator but also as an idea generator.
Sector Indices can a lot of time direct us to a specific part of the economy that is about to skyrocket in value.
This would probably mean a more concentrated or smaller capitalization index such as a housing index.
As we can see below, the sector index was very valuable in providing us with an insight that the current rally was not only involving all the other stocks but also constructing stocks that rarely will rise sharply in price.
The bottom was not easy to pick, however, after the first big positive weeks, we were able to identify the beginning of an upward trend and include some of these 3 constructing stocks in our portfolio.

Source: TradingView

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In conclusion, Indices are useful tools that can be used in many portfolio’s procedures to provide insight into the trend or momentum bias of the market/sector.

In many cases, their signals are not the fastest but rarely do they fail to set the right tone for an investor that is willing to be active in his/her portfolio.

Disclaimer

The views expressed do not constitute investment or any other advice/recommendation/
suggestion and are subject to change. Reliance upon information in this material is at the sole discretion of the reader. Opinions expressed in the report do not represent the opinion of ZuluTrade Social Trading Platform and do not constitute an offer or invitation to anyone to invest or trade. Every metric and the statistical number is a result of a past performance, which does not constitute a promise or a certainty for a future one.

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