Benefits of trading Indices
- Risk Management for your Trade portfolio – Low volatility when trading Indices as its performance is based on the average of a group of companies rather than one and thus your investment is at lower risk.
- Indices Market is open to trade around the clock, making it high flexible and presents many potential opportunities.
- When trading market Indices you will be open to the returns and opportunities generated from a whole industry/sector rather than just a single company stock.
- CFDs allow for leverage, which Traders can take advantage of and make more of their investments.
- Easy to use trading platform makes Trading and analysis much easier.
What are indices in trading?
Index trading is a popular way for traders to gain exposure to financial markets without having to invest in individual company stocks, bonds, commodities or other assets directly.
Those who are new to financial markets often start with index trading, meaning they trade an index-tracking fund or a basket of shares, instead of buying and selling individual company stocks.
By tracking the performance of a large group of shares, a stock index aims to reflect the state of a broader market, for example, the stock market of a country or a specific sector. This means that indices tend to be diversified.
Every one of the world’s major financial markets has at least one stock index to represent it. For example, the S&P 500 (US500) is an index of the 500 largest companies in the US. As these benchmark indices often reflect the performance of the overall stock market, movement in the benchmark’s value indicates the health of the economy or industry sector it tracks.
Another benchmark index, the Euronext 100 (N100) tracks the performance of the largest stocks on Europe’s Euronext exchange, comprising companies listed in the Netherlands, France, Belgium, Portugal and Luxembourg. Other major indices include the UK’s FTSE 100 (UK100), Germany’s DAX 40 (DE40), Hong Kong’s Hang Seng (HK50) and Japan’s Nikkei 225 (J225).
Equity indices provide benchmarks for fund managers to measure their actively managed fund performance against. Fund providers also create passive index-linked funds, associated derivatives are also available for investors to buy and sell.
Passive funds, also known as tracker funds, hold stocks in the same proportion as the index to match its performance. Active funds are managed by fund managers, who aim to outperform the index. Fund managers charge an annual fee as a percentage of the fund’s value.
Exchange-traded funds (ETFs) are an increasingly popular way for investors to get started with stock indices trading. ETF fund managers, such as Vanguard, charge relatively lower fees, allowing investors to keep more of their returns.
As they are traded on exchanges, the price of these funds fluctuates throughout the trading session, unlike a mutual fund for which the price is settled once daily. ETFs can be bought and sold quickly and easily through stock trading platforms.
Dividends paid on the company stocks in an index-tracking fund can be distributed to investors, known as a distribution fund, or reinvested back into the fund, known as accumulation fund.
How are stock market indices calculated?
The first trading indices were calculated as simple averages. The share prices of all the constituents were totaled and divided by the number of companies. However, today some major indices such as the Nasdaq 100 (US100) and the Hang Seng are weighted averages.
Stock indices are calculated in different ways based on the types of companies they track and the goals of the index. Some index calculations give more weight to stocks with higher prices, while others base the weighting on market capitalization, and others weigh all constituent stocks equally. The two major formulas used to calculate the value of a weighted index are price weighted and market cap weighted.
Price weighted
In price-weighted indices, the stocks are weighted in proportion to their share price rather than the size of the company. This means that companies with the highest share prices have a stronger impact on the value of the index.
Price-weighted indices are less common than those based on market cap. The Dow Jones Industrial Average (US30) in the US and Nikkei 225 are both price-weighted indices.
Market capitalization-weighted
A market capitalization weighted index uses the value of its constituent companies to rank them. Market cap is calculated by multiplying a company’s stock price by the number of outstanding shares. Companies with the largest market capitalization will have the highest influence over the index’s value.
Market capitalization
The market cap of each company is calculated based on free float shares publicly available for trading. A company’s free float market cap is lower than its total market cap, as it excludes shares held by company insiders. The FTSE 100 and DAX 40 are examples of market-value-weighted indices.
Unweighted
An unweighted or equal weight index gives the same weight to each of its constituent companies. This limits the influence that one stock can have on the overall performance of the index, reducing volatility while also dampening the effect of a sharp rally in a particular stock.
The S&P 500 Equal Weight Index (EWI) is an equal-weight version of the S&P 500 that offers an alternative for traders looking into trading indices with more price stability.
How are indices compiled?
Indices are managed by committees, which set the criteria that company stocks must meet to be eligible for inclusion.
These committees meet regularly to review the index rules and decide whether to add or remove companies. Some committees hold reviews quarterly, while others do so annually.
Committees can remove stocks that no longer meet the eligibility criteria, while others allow them to remain, or give them time to return to compliance.
Types of indices
There are many different types of stock indices catering to trader needs: global, regional, national, exchange-based, industry, currency and sentiment-based.
However, in addition to stock index trading, you can also trade commodity and bond indices.
Stock
A stock index is calculated from the price of its constituent stocks. Any index lists the criteria a company must meet to qualify for inclusion.
Benchmark stock market indices are often referred to in financial news reports. They’re considered indicators of business confidence, performance and economic health.
Trading indices linked to specific industries is also popular among traders. For example, the NASDAQ 100 lists the biggest non-financial companies listed on the NASDAQ stock exchange. As its composition is tech-focused, it’s often used as a barometer of the US technology sector’s performance and is one of the go-to choices for stock index trading.
Commodity
Indices that track commodities tend to follow spot or futures contracts representing the price of a commodity, such as crude oil, gold, silver, copper, coffee, sugar.
For example, the S&P GSCI Crude Oil Index provides investors with a benchmark while the United States Oil Fund tracks the daily price changes for West Texas Intermediate (WTI) crude oil.
There are also commodity-linked stock indices that represent stocks in companies involved in the commodity sector, such as mining companies or oil and gas producers.
The Energy Select Sector SPDR Fund (XLE) tracks the Energy Select Sector index, which is composed of large-cap US companies in the oil and gas market, as well as energy equipment firms. The VanEck Junior Gold Miners ETF (GDXJ) invests in stocks of small gold mining companies, with the MVIS Global Junior Gold Miners Index as its underlying index.
Bonds
Bonds are fixed-income securities that represent a unit of debt. When investors buy bonds, they essentially lend money to the bond-issuer, with an interest charge included in repayments.
Bond indices are designed to measure the performance of certain sectors of the bond market, such as corporate bonds, government bonds and municipal bonds. The S&P 500 Bond Index, which follows corporate bond performance, is designed to be a counterpart to the S&P 500 Index in gauging market returns.
Currencies
Currency-based indices aim to track the performance of the underlying currency. For example, the US Dollar Index (DXY) measures the value of greenback against a basket of other currencies. It is a leading international benchmark for the value of the US currency.
Other examples include Euro Currency Index (ECY) and British Pound Currency Index (BXY), and many more.
Sentiment
Sentiment-linked indices follow a measure of sentiment in the markets, such as volatility. One of the most famous sentiment indices is the Chicago Board of Options Exchange (CBOE) Volatility Index (VIX), which measures volatility in S&P 500 index option contracts.
When VIX rises, it means that there is increased volatility in the stock market, typically associated by market fear and sell-off. When VIX is low, the equities tend to be relatively stable.
What moves the index price?
The factors shaping an index price would largely depend on what assets the index consists of.
For example, stock market index prices fluctuate based on constituent companies’ share prices. For commodity indices, on the other hand, commodity prices are crucial drivers.
Economic news
Gross domestic product (GDP) data, which is announced quarterly, as well as monthly data on industrial production and consumer prices, are important drivers for the stock and FX markets. Positive economic releases in the US, for example, could boost the US dollar index higher.
Interest rates set by central banks, such as the US Federal Reserve (Fed), Bank of England (BoE) and European Central Bank (ECB) affect the broad performance of stocks and currencies.
Expansionary monetary policy, including lower interest rates and active asset purchases, tends to drive stock market rallies triggering risk-on sentiment, whereas increased interest rates tend to weigh on stocks.
Company financial results
Companies that are publicly listed on stock exchanges are required to release their financial statements quarterly or half-yearly, depending on the exchange.
The period after the end of a quarter, when companies announce their results, is known as the earnings season. Stock index volatility tends to increase during reporting as traders react to the financial results of the companies.
Company announcements
Along with earnings reports, other announcements from companies – such as new product announcements, mergers and acquisitions (M&A), and changes in the top management – can have an impact on stock prices. This, in turn, can move a stock market index.
Changes to index composition
Some stock market indices rebalance on a regular basis to ensure all their constituent companies continue to meet the listing requirements. The S&P Dow Jones and MSCI indices are rebalanced on a quarterly or annual basis following a review by their index committees.
There may be a higher volatility around an index rebalancing event, yet those changes are typically known in advance and are likely to be priced in.
Currency movements
Currency movements affect both stock market and currency indices. Stock indices weighted towards companies that generate most of their revenues abroad can be influenced by currency exchange rates.
For example, the FTSE 100 (UK100) includes companies that have benefited from weakness in the value of the British pound (GBP) in recent years, as they received higher income when converting sales revenue in foreign currencies into pounds.
Geopolitical events
Elections and other political events can affect stock and FX market performance. US presidential elections exert an influence over markets internationally; as investors consider the impact, the policies of an incoming administration are likely to have on the world’s largest economy.
Russia’s invasion of Ukraine has had a strong impact on markets amid Western sanctions on Russia and disrupted supply chains, driving up prices for energy and food.
Investor sentiment
Sentiment among stock market investors has a strong impact on index values. Indices sold off across the board at the start of the Covid-19 lockdowns, as investors anticipated the collapse in demand causing a recession. They started to rebound once vaccines were trialed successfully.
In 2022, rising concerns about the potential for a new recession caused by rising interest rates and high inflation have weighed heavily on stock indices.
Commodity prices
Commodity indices are naturally driven by prices of the commodities they track, whether they measure prices directly or track companies involved in the industry, therefore having an impact on commodity-linked stock market indices too.
For example, share prices for the major oil and gas companies have climbed as crude oil prices have rallied, lifting the indices that follow their stocks.
