What Are Indices and How to Trade Them?

Indexes, or indices, are a representation of the value of a subset of a market, whether that subset is small or almost the entire market.

Listen for more information on index construction and how traders can trade each index.

Transcript

What Are Indices and How to Trade Them?

Indexes, or indices, are a representation of the value of a subset of a market, whether that subset is small or almost the entire market.

While stock indexes are the central focus here, it’s important to recognise different indexes exist in other financial markets and function mostly in the same manner, such as the US Dollar Index (particularly useful for Forex trading).

Made up of a basket of stocks (constituents – a company with shares that form part of an index listed on an exchange), stock indices provide an accurate way of gauging overall market sentiment. They also act as benchmarks against individual stock portfolios.

Depending on the index, calculation methods vary. Most of the popular indices are calculated according to market capitalisation (often referred to as market cap), while others are price-weighted. Indexes calculated by market cap deliver a greater weighting to larger-cap stocks – their individual performance influences an index’s value more than low-cap stocks. As an example, a company that has a market cap of $10 billion receives ten times the weight a company with a market cap of $1 billion. Price-weighted indexes operate differently, presenting a larger weighting to companies with higher stock prices (share prices).

 Popular Stock Indices

• Dow Jones Industrial Average (DJIA is composed of 30 large-cap US stocks, weighted by price)
• S&P 500 Index (tracks the value of 500 large-cap shares in the US, weighted by a float-adjusted market-cap)
• Nasdaq 100 (follows the performance of 100 of the largest non-financial stocks listed on the NASDAQ exchange and is weighted by a modified market-cap methodology [it effectively doubles down on the best performing constituents consequently capping the influence of larger components])
• FTSE 100 (measures the value of 100 of the largest companies listed on the London Stock Exchange [LSE] and is weighted by market cap)

Other common stock indices are Germany’s DAX 40 (tracks 40 major German companies), France’s CAC 40, Japan’s Nikkei 225 and Australia’s S&P/ASX 200.

Like most indexes, the ‘cash price’, cannot be traded directly. Indexes are in place for informational purposes and tend to be viewed as a standard for a country’s stock market. Fortunately, financial derivatives products, such as futures, options and contract for differences (CFDs), provide an avenue to trade stock indexes.

Indices Trading: How to Trade Stock Market Indices

• First and foremost, traders must decide which index (or indexes) to trade. You may choose to trade just one index, particularly if you’re a day trader. It’s important to point out when trading CFDs, stock indexes are branded differently for trademark reasons (UK 100, Wall Street 30, for example), yet they ultimately track the underlying index price movement via futures contracts (index futures).
• The next step is to consider researching the constituents that make up an index. While this does not mean combing through each individual company, it is worth spending time recognising which sectors (and industries) influence the index. For example, nearly 50 percent of the market cap in the Nasdaq 100 is composed of five technology companies: Apple (AAPL), Amazon (AMZN), Microsoft (MSFT), Facebook (FB) and Google (GOOGL). Consequently, a rally in the technology sector will influence the price of the Nasdaq 100.
• Technical analysis or fundamental analysis? There are benefits for both. This is why many traders elect to analyse markets using a combination of both mediums to locate trading opportunities. Technical analysis does a superb job of answering the question as to when to start trading a particular index; fundamental analysis, however, answers the question why a market should move in a specific way.
• Long-term position trading or short-term day trading? There are four central trading styles to consider: scalping, day trading, swing trading and position trading (when position or swing trading, you’re less concerned with minor daily price fluctuations). Which style you select ultimately determines which timeframe your trading system (trading strategy) follows. It is recommended to back test (and forward test) any trading system on a demo account prior to trading live. This also provides an opportunity to refine risk-management and money-management strategies. Consider opening a demo trading account with FP Markets here. It takes less than a minute to get going.

FP Markets provides exposure to major global stock indices through index CFDs at competitive leverage on world-class trading platforms.

We’ve partnered with leading banking and non-banking financial institutions to ensure a deep liquidity pool, so traders receive the best available market prices with competitive spreads. FP Markets recommend MetaTrader 4 (MT4) for global Indices, though a range of products are available on MetaTrader 5 (MT5) and Iress platforms.