A frequently asked question by most traders is ‘what is the best strategy to use while trading these volatile instruments?’ With the increasing influx of traders to synthetic indices.
Synthetic indices, otherwise known as synthetic assets or volatility indices, are one of the relatively new but fast growing areas within trading.
These instruments simulate real-market conditions and provide traders with the ability to trade on volatility without being dependent on conventional markets such as Forex or stocks.
In this article, we explore some of the most viable trading strategies for synthetic indices, focusing on volatility-based strategies, risk management, and detailed techniques for successfully trading this unique market.
Whether you’re a beginner or a professional trader, being able to understand how to adapt strategies for synthetic indices is critical in your quest for success.
Understanding Synthetic Indices
Before diving into the strategies, it is crucial to understand what synthetic indices are and how they work. Synthetic indices are artificial markets created by brokers, designed to mimic the movements of real-world assets but with unique characteristics.
Unlike traditional markets, these indices do not tie to real-world assets like stocks or commodities. They operate 24/7, allowing traders to engage at any time, and are often less affected by fundamental news events.
The most notable feature of synthetic indices is their volatility. These markets are engineered to simulate the price action seen in real markets but with higher volatility and more frequent price swings. This volatility creates both opportunities and risks, making it essential for traders to have a solid strategy in place.
Key Strategies for Trading Synthetic Indices
1. Trend Following Strategy
The trend-following strategy is one of the most popular and effective methods for trading synthetic indices. As the name suggests, this strategy involves identifying the direction of the market and entering trades that align with that trend.
The principle behind this strategy is simple: “The trend is your friend.” By following the trend, traders can capitalize on sustained price movements, which can result in consistent profits over time.
To successfully implement a trend-following strategy, traders must first identify the prevailing trend. This can be done using various tools and indicators such as moving averages, trendlines, and the Average Directional Index (ADX).
For example, a trader might use a 50 period moving average to determine the trend direction. In a trend-following strategy, entering early at the trend’s start and exiting at signs of reversal is key. Indicators like RSI or Stochastic Oscillator help identify overbought or oversold conditions, signaling possible reversals.
2. Range Trading Strategy
Although the strategy of following the trend works in a trending market, synthetic indices also have consolidation phases wherein prices are moving within a particular range. In such scenarios, this range trading strategy becomes very effective. In this trading, one would buy at the support level and sell at the resistance level to make the most of price oscillations between these two points.
One needs to find out the main resistance and support levels. These levels are price points from which the market has reversed or stalled in the past.
Traders can increase their success rate in range trading by waiting for price rejection at support or resistance levels and confirming overbought or oversold conditions with oscillators like RSI or Stochastic, avoiding false breakouts and trends.
3. Scalping Strategy
Scalping is a short-term trading strategy focused on quick, small profits from minor price movements in synthetic indices, with trades lasting only a few minutes.
Successful scalping requires traders to identify short-lasting patterns and use indicators like MACD or Bollinger Bands for entry or exit signals.
One important thing to consider with the scalping strategy is strict risk management. While profits from one scalp are small, if not managed well, losses could add up quickly. For that reason, traders should always set tight stop-loss orders and use appropriate position sizing to protect their capital.
4. Volatility-Based Strategy
Synthetic indices are known to have relatively stable price action; however, they can still be naturally volatile at times, which presents profitable opportunities to prepared traders. The volatility-based strategy will look to capitalize on the price movements during increased volatility.
Many traders enact this strategy through the utilization of volatility indicators such as ATR or Bollinger Bands, among others. These indicators measure market volatility, signaling potential strong price movements.
For example, when ATR shows rising volatility, breakout opportunities may increase, or stop-loss orders may be set wider. However, volatility is unpredictable and can cause sudden reversals, so caution is essential. A decent risk management plan is very crucial for the trader to be safe in such volatile conditions.
5. Breakout Strategy
The breakout strategy involves identifying key levels of support and resistance and waiting for the price to break through these levels. When a breakout occurs, it often signals the beginning of a strong trend.
Traders using this strategy enter the market when the price breaks a key level, capitalizing on the resulting momentum, with the help of technical tools like trendlines, support/resistance zones, and price action patterns.
A well constructed breakout is usually accompanied by high trading volume, which confirms the strength of the move. Indicators like the Volume Oscillator and On-Balance Volume help confirm breakout validity, while tools like RSI or MACD can filter false breakouts.
6. News Trading Strategy
Although synthetic indices are, by definition, not affected directly by actual news events, some brokers or platforms may include economic data or other market-moving events in their synthetic index models. Therefore, knowledge of the latest news and events that could impact synthetic indices is important.
News trading involves tracking economic reports, earnings, geopolitical events, and other news that may influence synthetic index movements, using calendars and trackers to identify key events. Traders often set tight stop-loss orders and limit orders to prevent unforeseen market volatility.
Important Factors to Consider for Trading Synthetic Indices
While using the appropriate strategy is vital, there are several other important things to consider while trading synthetic indices:
1. Risk Management: As with any form of trading, risk management is paramount. Traders should set stop-loss orders, size positions wisely, and risk only a small portion of their account per trade.
2. Discipline/psychology: Trading will drain you mentally, so keeping your head straight and composed against rash decisions can be effectively put into practice with a pre-formulated plan in place.
3. Selection of Broker and Trading Platform: Choose a proper, reliable broker offering synthetic indices. It may involve a number of factors when it comes to choosing your broker, depending on different things such as trading fees, speed of execution, customer support, or other key considerations.
4. Backtesting: Traders should, before committing real capital into a strategy, backtest their strategies using historical data to determine the effectiveness of the strategy and make any necessary adjustments.
Frequently Asked Questions (FAQs)
What are synthetic indices?
- Brokers or trading platforms create synthetic indices as financial instruments that simulate market conditions without being influenced by real-world assets like stocks, commodities, or currencies. They provide a stable and predictable trading environment that operates 24/7. Platforms like Deriv offer synthetic indices with consistent price movements and lower volatility than traditional markets.
Can I trade synthetic indices 24/7?
- Synthetic indices can be traded 24/7, offering flexibility for both full-time and part-time traders to enter and exit positions anytime.
How do I identify trends in synthetic indices?
- Indicators of trends that work for synthetic indices include the moving average, the trendline, and the Average Directional Index, or ADX. If the moving average goes up, it is an uptrend; if the moving average falls, then it is a downtrend. It helps to confirm the strength and direction of the trend when a trend indicator is combined with confirmation tools such as RSI or MACD.
What is the risk of trading synthetic indices?
- Being a form of trading, there is risk associated with synthetic indices. Their typically stable prices offer opportunities for profit, but volatility can sometimes cause sudden losses. Therefore, good risk management is required, such as stop-loss orders, proper position sizing, and avoiding overtrading.
How can I avoid false breakouts in synthetic indices?
- The price creates a false breakout when it has gone through the level of support or resistance for a short time before turning in the opposite direction. In order to reduce the occurrence of false breakouts, confirmation tools like RSI, MACD, or volume analysis are helpful. A breakout confirmed with volume and supporting indicators is most likely a valid breakout. The same effect can be reached by waiting for price consolidation or retests to confirm a breakout.
Can I trade synthetic indices using fundamental analysis?
- Some platforms may model synthetic indices to include economic events, despite these indices being unaffected by traditional economic data or news. Technical analysis tends to serve better when trading synthetic indices, as the price movements are predictable and stable in nature. Having said that, it is always good to keep an eye on the general news in the markets, which could influence overall market sentiment.
