What are indices?
Indices are a measure of a section of shares in the stock market. Indices are created by combining the value of several stocks to create one aggregate value. Major financial indices include the Dow Jones Industrial Average, FTSE 100, CAC 40, and Dax 30. The Dow Jones Index, for example, represents 30 large publically-listed companies traded on the New York Stock Exchange.
Indices often provide a measure of the price behaviour of a particular sector – they represent the top shares in a specific exchange. Indices can also be used as a tool to gauge the health of a market, and to compare returns on specific investments.
There are many types of indices available to trade. Indices can be categorised by geographic location, industry sector, or company size. Some indices are categorised by the size of the companies they represent, such as the S&P SmallCap 600 and S&P Composite 1500. This helps provide investors with many trading opportunities. Businesses within an index must meet specific criteria. Companies within the S&P 500, for example, must have a certain market capitalisation.
Corporate action of individual shares listed on an index can impact the overall value of an index, for example, mergers and the issuing of additional shares. Most large indices are recalculated on a quarterly basis and any constituent share that no longer meets the minimum criteria required to be on the index is dropped and replaced by another share that does.
Trading with indices
As indices basically represent the value of a group of assets or stocks, it’s not possible to buy or sell them directly. In order to get started with index trading, you would need to select a trading vehicle which reflects an index's performance. Products such as mutual funds, ETFs (exchange traded funds), spread betting (UK and Ireland only) and CFDs (contracts for difference) can all track the price of an underlying index. You can also trade stock indices through forward contracts, which is a contractual agreement between a buyer and seller for a future date.
Once a trader has selected a trading product, they are ready to trade. If on average the share price of the companies within an index goes up, the value of the index will rise along with them. If these companies’ share prices fall, the value of an index will drop. Since indices are made up of many stocks, their value tends to fluctuate. Some indices are more volatile than individual shares. This has the benefit of numerous trading opportunities, but can also add risk for the trader.
Most major economies have a financial index. In the US there is the Dow Jones Industrial Average and NASDAQ, and also the Standard & Poor’s 500 index (S&P 500). Britain has the FTSE 100 index, while Germany has the DAX 30 index. France has the CAC 40. In Asia, there is the Hang Seng in Hong Kong, and Nikkei 225 in Japan. The ASX 200 index is traded in Australia.
Different stock exchanges deal with different types of stocks. Some only incorporate a particular industry. The NASDAQ index, for example, only lists technology stocks. There are other smaller indices which can be traded, depending on the trading platform a trader chooses to use. If a trader wanted to trade stocks online, there are no real barriers and many options to choose from.
Trading indices via a mutual fund is a popular way to invest. A portfolio is set up to match the performance of a particular index. Mutual fund managers provide index funds that track the S&P 500, for example. The first of these was the Vanguard Group’s Vanguard 500 in 1976. These funds often offer broad market exposure.
How are stock indices calculated?
The value of an index depends upon many factors. These include company productivity, prices, and employment. In order for a company to be added to an index, it could be selected by a committee, as is the case with the S&P 500. The committee will consider the eligibility of each new addition based on strict criteria, such as market capitalisation, financial viability, and length of time it has been publicly traded on the stock exchange. Otherwise, there will be rule-based entry, as exists with the Russell 1000 index, which consists of small companies.
Different indices are calculated differently. Most are calculated using a capitalisation-weighted average. This means that the size of each company within an index will impact the value of the index. The more a company is worth by market cap, the bigger impact its share price will have on the index overall.
Indices can also be price-weighted. Indices falling into this category are the Dow Jones Industrial Average and Nikkei. A price-weighted index sums up the price per share for each stock included within it. The sum is then divided by a common divisor, usually the total number of stocks in the index. It is useful for traders to have knowledge of how an index is calculated.
As an indicator or benchmark of the top-performing businesses in a particular industry, the value of an index is affected by the performance of its constituent companies. Benchmarking can be used to measure a fund or stock’s performance. Market indices will typically be used as a benchmark, as they can give a broad market view for comparison. Indices can help to track a market’s changes over time. An investor might use the S&P 500 as a benchmark to assess their own portfolio’s performance, for instance.
Indices with a lower volatility are also available for trading, such as the S&P 500 Low Volatility Index. However, rising interest rates can negatively affect the performance of such indices. This is due to the characteristics of sectors usually linked to these strategies, such as utilities and staples. Investors would do well to note that low volatility indices have exposure to rising interest-rate risk.
Indices can be traded using financial products such as spread bets or CFDs. Here, a broker or trading platform will allow traders to open a position by depositing only a percentage of the full value of the trade. This is called leveraged trading or trading on margin. When the market moves in favour of the trader, they can make substantial profits by depositing just a percentage of the full value of one’s trading position. Margined trading can, however, also result in significant losses if the market moves against the trader.
Difference between indices and indexes
Indices are also known as indexes, so there is no real difference between the two. The word ‘index’ has two acceptable plural forms, which can cause some confusion. When it comes to trading, an index is the measure of several stocks to create one value. There are different ways that investors can capitalise on indices. Index funds are a type of mutual funds which incorporate stocks that follow or track the components of a particular market index.
Advantages associated with an index fund are broad market exposure, low operating expenses, and low portfolio turnover. Portfolio turnover is a measure of how often assets within a fund are bought and sold by managers. This needs to be considered by investors, because a high turnover rate will incur more transaction costs than a fund with a lower rate. That is, unless the new asset selection’s returns offset the added transaction costs they bring.
Index investing is another method which allows investors to reproduce the performance of indices. This strategy replicates the movement of an index through the use of ETFs. The exchange traded fund acts as an index tracking instrument. It is made up of the same stocks that comprise a particular index. The ETF closely monitors and shadows the underlying stock market index.
Investors can use index values to follow market trends and other developments, and it is also possible to purchase an indexed annuity, which is a life insurance product. Returns are linked to an index such as the S&P 500. This type of annuity produces gains based on a specified equity-based index. Because the annuity is fixed, capital is protected from market volatility.
Risk of trading indices
Trading indices is considered by many to be a lower-risk strategy, as one is spreading their risk across an entire segment or sector, as opposed to a single stock. However, there are still some risks involved. This is because one is trading a derivative instead of a physical asset. Here, a derivative is an instrument that obtains its value from the price of an underlying asset, such as an individual stock or stock index. The risk is that the movement of just one stock or security within the index could have a major impact on the value of the index.
It’s important to do some research prior to trading indices. Collecting news and analysis can help traders make better-informed decisions. It’s also a good idea to make use of risk management tools. Most trading platforms offer a range of risk management tools and resources to help traders protect their positions against sudden market moves. These include stop-loss orders and guaranteed stop losses. A stop-loss order will, for instance, close a losing trade once price passes a trigger value pre-decided by the investor. These are very effective in the event of sharp price action. Another effective risk management tool when trading indices are limit orders. Limit orders are used to enter a trade at a specific price above or below the current market price, and within a set time period.
Disclaimer
CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.
CMC Markets does not endorse or offer opinion on the trading strategies used by the author. Their trading strategies do not guarantee any return and CMC Markets shall not be held responsible for any loss that you may incur, either directly or indirectly, arising from any investment based on any information contained herein.
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