An Introduction To Stock Indices Trading

Jan 27, 2021 10:04 PM ET
An Introduction To Stock Indices Trading

What are stock indices? Indices are a frequently speculated financial instrument with connections to the stock market. Many analysts believe indices are a better investment than single stocks due to the diversification aspect; hence why all media and the general public keenly follow them.

Overview

In the world of stocks, you may have heard of ideas such as 'beating the S&P 500'. Well, what is the S&P 500, and why does it seem so revered? The S&P is one of several instruments in the realm of stock indices, a highly speculated financial market. 

It may be interesting to gain an introduction to this instrument by taking a brief look at what it is, what drives its prices, methods of investing, a list of some popular indices, and some of the benefits and drawbacks

stock indices

What are indices?

Indices are the plural form of the word index. An index is a tradeable financial instrument acting as a collection or basket of several other markets, most notably stocks (but can also include currencies, commodities, etc.)

Stock indices are particularly prevalent, often being reliable yardsticks of a specific market sector in a country and its economy overall. The legendary Charles Dow and Edward Jones are credited as the creators of the first stock index back in May 1896, known as the Dow Jones Industrial Average (DJIA).

Both men conveniently serve as an excellent example of a prominent stock index. The DJIA aims to measure the performance of the 30 biggest listed American corporations. DJIA's value is the sum of all 30 stock prices divided by a continually changing factor of 0.152 (at the time of writing). 

The methods of how stock prices are mathematically computed or calculated within the index vary from market capitalization, free-float market capitalization, price, fundamental factor, equal, volatility, and minimum variance weightings.

The purpose of indices

As with any financial market, it helps to define its purpose. Appreciating stock indices is to know the meaning of the stock market itself. The stock market acts as a mechanism for companies to grow by using capital from shareholders.

After acquiring this extensive funding from the sale of new stocks or shares, a business can expand, ultimately increasing its bottom line. In many cases, from the shareholders' perspective, they should receive dividends as a reward or see an increased gain in owning the stock.

Corporations are seen as paramount to the health of any economic sector. If more of them continually perform well, aside from the profit expansion, this allows for more employment. When there are more jobs, the economy inevitably also improves within a specific sector (and the cycle repeats). 

For example, analysts consider the NASDAQ Composite Index as an excellent barometer of the tech sector's health in the US due to the many tech-related stocks on the NASDAQ. 

What drives the prices of indices?

Like any financial market, indices move due to mainly technical, fundamental, and sentiment analysis factors. Since an index weighs itself against a basket of tens to thousands of individual stocks, these constituents' fluctuations affect its value overall. 

However, the beauty of indices is investors don't need to track each of these separately other than observing the index. From a technical analysis lens, traders attempt to forecast price changes using various indicators and chart patterns. 

The attitudes derived from these findings by market participants do play some role in future prices. We could argue indices are far more trend-heavy than a market like forex that is more dynamic. Several indices can remain in sustained bull or bear markets for years due to specific fundamental factors. 

While events affecting an individual stock are insignificant to an overall index, those occurring in its corresponding sector are anything but. Fundamental analysis should look to incorporate observing economic sector data, and government policies, among other things.

Methods of investing in indices

An advantage is keen indices investors can either trade index CFDs (contract for difference) through a broker or buy an index fund. The latter financial product tracks the performance of a particular index and is the actual underlying asset itself. 

An index fund can typically be either a mutual fund or ETF (exchange-traded fund). A mutual fund involves a pooled pot of several investors' money handled by a professional money manager investing in one or a variety of stock indices. 

ETFs are similar to mutual funds, with the exception of being traded on a stock exchange. Overall, index funds are more of a passive investment form than index CFDs.

List of popular indices 

As expected, many of the most speculated indices come from the United States. However, there are other prominent ones in a few first world countries.

  • S&P 500 – an index tracking the performance of 500 of America's most valuable listed companies 
  • Nikkei 225 – an index tracking the value of 225 of the largest Japanese corporations listed on the Tokyo Stock Exchange.
  • FTSE 100 / 'footsie' – an index measuring the value of the top 100 companies listed on the London Stock Exchange.
  • ASX200 – an index tracking the performance of the 200 largest companies listed on the Australian Securities Exchange
  • GER 30 / DAX – an index measuring the value of the top 30 German brands listed on the Frankfurt Stock Exchange

Pros and cons of indices trading 

As with any financial market, indices trading presents unique benefits and challenges simultaneously.

Pros

  • Experts consider trading indices a smarter alternative to speculating on individual stocks since your risk spreads on a large collection of shares. Hence, many believe an index should form part of any diversification strategy. 

Additionally, investors also gain knowledge about how a particular sector of the broader economy is performing overall.

  • There is less leverage given to traders with indices, fostering more responsible trading (although there are equally some drawbacks here).

Cons

  • On the first advantage above, while several stocks combine to form an index, it can be harder to analyze fundamentally. There are more fundamental and other factors moving an index than an individual stock.
  • Indices (and stocks generally) are not traded around-the-clock as with the forex and cryptocurrencies markets. 
  • The lower leverage (usually between 1:5 and 1:20 on average) brokers afford to traders means indices require much higher trading capital than a few other instruments. 
  • Certain indices may incur higher swap fees or commissions.

Conclusion

Indices are an excellent gateway into an ambitiously speculated branch of stocks that has existed for several decades. Generally, people venturing into indices for the first time may have had substantial experience on other instruments first since indices do require more capital.

Nonetheless, like any financial market, success is entirely dependent on a trader's skill in technical and fundamental analysis, and lastly, how they handle risk and money management.


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