Index titling is a strategy that can be applied when a trader has a bias towards a particular market sector.
There are a number of ways to determine the value of various stock indices – one of these is through capitalisation weighting, which factors in the size of each of the companies in the index as well along with their share prices. This results in the impact of a company’s price change on the index being proportional to its overall market value.
If a trader chose to invest in the S&P/ASX 200 Index, BHP Billiton, the largest company in the index, would have the largest impact on the index’s value. Next would come the big four banks – the Commonwealth Banks, Westpac, ANZ and NAB.
So if a trader believed that Australian financials were overbought, he could take a short position on the entire market by selling an index CFD. In the case of the ASX 200, this any movements in the financial industry would significantly impact the index as a whole because four of the five largest companies in the index are banks.
However, if the trader thought the utilities sector was going to be dragging the market down, the natural weighting of the index wouldn’t be very beneficial – the largest utilities company on the index is AGL Energy, and it only has a 0.55% weighting on the index as a whole; this is very small compared to BHPs 13.11%, or the combined 22.91% of the big four banks.
Instead of just taking a short position on the entire index, a trader could sell additional utilities contracts. By holding relatively few financial and materials contracts, and more stocks in utilities, a trader could tilt the index away from materials and financials towards utilities.
This strategy is how managed funds are able to outperform various stock indices.