What are Indices and Where can I trade them?

There are many financial derivatives out there, and indices are one of those derivatives that traders and analysts follow on a daily basis. They have become a very important part of every financial market because of what they represent in the market.

 

While you cannot directly invest in market indices, there are ways to gain exposure to them or speculate on their price movements. But before we get into that, let’s find out what an index is and how it is derived.

Content List

1) What is an Index?

An index is a measurement of the price performance of a group of securities in an asset class or a market. It consists of a portfolio of securities that represent a particular market or a section of it, and its value is calculated as a weighted average of the prices or market capitalization (in the case of stocks) of its constituent securities.

The market, here, can be the stock market, bond market, forex market, or commodity market. So, we have stock market indices, like the S&P 500 Index and the FTSE 100; the bond market indices, such as the U.S. Aggregate Bond Index; the currency market indices, such as the USD Index and the Euro Index; and the commodity market indices, like the S&P Commodity Index and the Rogers International Commodities Index.

However, stock market indices are, by far, the most common indices in the financial market. They are the indices that financial analysts talk about most of the time, and most online brokers offer their CFDs for retail trading. So, for the rest of this article, we will focus on the stock market indices.

A stock index is a statistical measure of the performance of a group of stocks listed on a particular stock exchange. Depending on the constituent stocks, an equity index may represent a section of the stock market or the whole of it.

 

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For instance, in the U.S. stock market, the Nasdaq Index, which is dominated by tech stocks, is often used as the benchmark for the technology sector of the market, while the S&P 500 Index, which consists of the 500 most capitalized stocks listed on the NYSE, is used gauge the U.S. stock market.

Apart from the S&P 500 Index and the Nasdaq Index, other popular equity indices of the U.S. market include the Dow Jones Industrial Average (DJIA), which represents 30 large stocks on the NYSE, and the Russell 2000 Index, which measures the performance of 2000 smallest cap stocks in the Russell 3000 Index — a basket of 3000 biggest U.S. stocks.

Almost every major stock exchange in the world has an index that tracks the performance of the market. For example, the FTSE 100 Index represents the 100 largest stocks trading on the London Stock Exchange. Others are DAX 30, which represents the 30 largest stocks on the Frankfurt Stock Exchange; Nikkei 225, which measures the performance of 225 large companies on the Tokyo Stock exchange; and CAC 40, which is an index of 40 most capitalized stocks listed on the Euronext Paris.

 

Many of the major stock indices are re-balanced on a quarterly basis, so any constituent stock that no longer meets the minimum criteria required to be on the index is removed and replaced by another stock that does.

The value of any stock index is derived either from the prices or the market capitalization of the individual stocks that make up the index. But whatever the underlying parameter used in calculating an index, it is weighted according to the values of the individual stocks.

For the majority of stock market indices in the world, the value of the index is capitalization-weighted. What this means is that a company whose market capitalization (the product of the share price and the total number of shares outstanding) is higher contributes more to the index’s price. An example of a capitalization-weighted index is the S&P 500 Index

On the other hand, some major indices are price-weighted. In other words, a company with a higher share price has a greater impact on the price of the index. For example, a company with a share price of $100 will have ten times the impact of a company with a share price of $10. Examples of price-weighted indices include the DJIA and Nikkei 225.

 

Since an equity index is based upon individual stocks trading on an exchange, its value fluctuates with changes in the prices of the underlying stocks. So, if those underlying stocks increase in price, the value of the market index will go up, and if those stocks decrease in price, the value of the market index will go down.

Unlike other financial instruments, stock indices cannot be bought or sold directly. They are just indicators to track overall market sentiment, and they also serve as a benchmark to measure the performance of individual stock portfolios.

 

Although you can’t buy or sell an index directly, there are trade-able financial products through which you can speculate on the price movement of an index, and they include the following:

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An index fund is a mutual fund whose portfolio mirrors a stock market index. The fund manager selects and invests in stocks in accordance with the composition and weighting of the stock index the fund is meant to tract.

 

Being a managed fund, you will have to pay a management fee if you want to invest in an index fund. But because the fund manager doesn’t spend money on researching the stocks to pick, the management fees are lower than that of traditional mutual funds.

An ETF is a fund that trades on the stock exchange and can be bought or sold through a stockbroker during the trading hours, just like a normal stock. It automatically tracks a basket of stocks that make up the fund, and it is not managed by a fund manager. When an ETF is tracking a stock market index, it is known as an index ETF.

 

An example of an index ETF is the SPDR S&P 500 (SPY), which tracks the S&P 500 Index. So, if you want to gain exposure to the S&P 500 Index, you can do that through the ETF. You will be charged a management fee though. But it’s usually lower than that of an index fund.

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Another way to speculate on a stock index is by trading the futures contracts of that index. The futures market is a huge market for speculative traders, and since index futures are cash-settled, it is very good for speculation. Additionally, futures contracts can be traded with leverage.

 

One factor that can make futures trading less appealing, especially when compared with CFDs and spread betting, is the need to roll over expiring contracts and the inherent contango and backwardation effects. Moreover, the margin requirement is generally higher than those of CFDs.

The options market offers another way to trade stock market indices. Just like index futures contracts, index options contracts are always cash-settled, so no actual stocks are bought or sold. Both traders and investors use index call and put options to speculate on the price movement of a stock index.

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A contract for difference (CFD) is a derivative product that represents a contract between a broker and a trader to exchange the difference in the value of a security, from the time a contract is opened to the time it is closed. So, the trader doesn’t at any moment own the underlying instrument but can still benefit from favorable movement in the price of the instrument. CFD trading is purely for speculation, and with its little margin requirement, it is the easiest way to trade a stock index.

This is similar to CFDs, except that the profits made from spread betting are not taxable. Unfortunately, spread betting is only available to the U.K. and Irish residents.

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While you can trade individual stocks directly on the stock exchange or through CFDs and other derivatives, trading a financial product that tracks the performance of a stock index may be a better option. Here are why it may be preferable to trade a stock index over an individual stock:

·        A stock index offers you exposure to the entire market or at least, an entire industry.

·        There’s no need to start researching individual stocks; you are only guided by the overall market sentiment to buy or sell an index product.

·        Since a stock index consists of many stocks, no one stock can cause an extreme price movement in the index, so the price movement tends to be a lot smoother.

·        Most major stock indices are derived from the biggest stocks on an exchange, so there is enough activity in the underlying stocks to provide adequate volatility in an index, offering speculators numerous trading opportunities.

 

·        For an investor, a stock index (through an index ETF) is an easy way to gain access to a diversified stock portfolio because it is made up of several stocks.

Summary

Indices are indicators that track the performance of a financial market or a sector of the market by measuring a basket of securities in that market. Stock indices are more popular than others. Whilst you cannot buy or sell indices, there are several ways to trade them.

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This does not constitute investment advice or personal recommendations as your specific financial circumstances have not been considered. No warranty is given in regards to the accuracy and completeness of information. Past performance is not an indicator of future results.