What Are Indices How To Trade
You often hear about index trading, or the world’s major stock market indices, in TV news bulletins and in the financial pages of newspapers. You may also want to read about News Trading Strategy in Forex.
If you are thinking about trading indices and want to understand what the practice involves, this article walks through the essentials.
It covers what index trading is and what a stock index actually is, how indices are traded, the different ways to trade and invest in them, and the main advantages and drawbacks.
What are indices?
Economists describe an index as a hypothetical basket that measures the prices of the shares listed on a particular exchange, market or industry.
An index’s value is tied to all of the shares that make it up, so trading a given index works much like trading every share within it at once.
Using an index, a trader can make directional and corrective decisions and gauge the state or trend of the market objectively.
On an exchange, an index is a measure designed to track share prices in the market as a whole on a daily basis.
It works like a thermometer for the market: it shows whether the overall market level has risen or fallen, and it measures that move by the change in the index level, expressed in points.
Indices are used to track the performance of a basket of securities. If you trade a stock market index made up of several shares, for example, you effectively open positions on several shares at the same time.
This is one of the most economical and least demanding ways to diversify your portfolio across different sectors and trade a basket of shares.
Stock indices also let you trade based on your own strategy and view, rather than on the direction of any single economy, and without having to pick individual shares.
An index is a good way to study particular markets. It gives investors a way to measure the performance of their own portfolios and to adjust holdings that are not producing the results they want, so those holdings fall more in line with the market’s general trend.
A stock index is built from a group of exchange-listed companies whose values are added together and expressed as an index number that starts from a base year. The FTSE 100, for example, launched on 3 January 1984 with a starting value of 1,000.
Major stock indices such as the FTSE 100, FTSE 250 and S&P 500 began as a way to let investors compare shares, and different stock markets, more easily.
Today it has become straightforward for retail investors to trade the value of a stock index and take a view on whether it will move higher or lower.
What is index trading?
Although an index is a mathematical construct that cannot itself be traded, exchange-traded funds and CFD funds exist that represent the index, or that are priced based on it.
Index trading has become a popular alternative to traditional share dealing, because it gives traders a broader view across a group of companies.
It also reduces the risk of trading a single company’s shares and is a useful tool for managing risk, since it helps the trader decide whether to buy or sell.
For example, a trader might buy HSBC shares because they expect the share price to rise while, at the same time, selling shares listed on the FTSE 100, which can protect their investments against an adverse market move.
Indices are usually provided by data vendors and rating agencies, which is why many carry names such as FT, short for the rating agency Financial Times.
Indices follow strict methodologies and rules that determine how companies are classified and when they are removed. Companies must meet a number of criteria beyond market capitalisation, including their level of liquidity and how long they have traded at the required volume.
The FTSE 100, for instance, covers the 100 largest public companies on the London Stock Exchange, and the S&P 500 includes the 500 largest public companies on the New York Stock Exchange.
How to trade a stock index
Stock indices cannot be traded directly, because they are not real commodities; they exist only to provide information, so you cannot buy or sell a piece of an index.
Instead of buying and selling the shares themselves, people trade indices through financial instruments.
Long-term contracts, contracts for difference (CFDs) and forex trading all provide exposure to stock indices, and CFDs are the most widespread way of doing this.
Types of index trading and investing
There are several ways to invest in indices, depending on the financial instruments a trader wants to use and how much risk they are willing to take.
Index funds
Index funds can be either mutual funds or exchange-traded funds.
Mutual funds are collective investment vehicles that pool investors’ money to invest in all of the companies that make up the index.
Index funds typically charge investors in the region of 0.25% to 0.85%, which eats into returns as those fees add up.
Index funds of the mutual-fund type issue new units when investors buy into the fund, but they are not traded on the stock market the way shares are; they are priced only once a day.
Exchange-traded funds
Exchange-traded funds are similar to mutual funds and track the price of an underlying asset or group of assets.
An ETF represents an index, but unlike mutual funds that track indices, it trades on the stock market like an ordinary share, so its price moves continuously according to supply and demand from buyers and sellers.
Exchange-traded funds are cheaper than index funds, with fees ranging between roughly 3% and 4.5%.
Contracts for difference
These are derivative products created by a financial institution, in which the parties to the contract agree to pay the difference between the price when the position is opened and the price when it is closed.
CFDs are very popular with investors in the Arab world, and a number of brokers specialise in them.
CFDs are used to invest across all types of financial asset classes, not only stock indices.
Although CFDs can suit day trading, as a quick way to gain exposure to stock indices, they carry higher risk than exchange-traded funds and mutual funds.
That is because they are more expensive than the other two types, especially when held for long periods, owing to the overnight financing fees the issuer charges to keep the position open for the contract holder.
Options and futures
An options or futures contract gives the holder the right to buy an asset at a set price, but without the obligation to do so.
These derivative products were once limited to professional traders and institutions, but today they are more widely available, especially in the United States.
There are two sides to an options contract, buying the option or selling it: if you expect the share price to rise you can buy the option, and the reverse when you sell it.
Pros and cons of index trading
Like currency trading, investing in indices carries a number of advantages, but it also has several drawbacks, which we set out below.
Cons of index trading
A risky investment: short-term index trading carries significant risk, particularly if the trader cannot keep positions open long enough to reach a profit, cannot meet a margin call, or has no stop-loss in place while the index falls sharply, which can expose them to large losses.
That said, long-term investing is less risky than short-term trading, because losses on an index can be recovered over time.
Constant index volatility: an index is subject to constant swings and can rise or fall continually, as it is affected by domestic and global economies. Rising unemployment or inflation, for example, can prompt investors to sell the index.
Pros of index trading
Fast, low-cost execution: a main advantage of index trading is how quickly and easily it can be carried out, since investing in a whole index can be done with great speed and ease. It also tends to cost less than other types of trading, depending on the instrument the trader chooses to use.
Diversification: a trader can invest in shares that are relatively uncorrelated, which means that when one falls in price another may rise, given the different sectors of the economy they operate in.
Before you start trading indices, it is worth consulting specialists in the field, choosing a strategy that suits you, and studying the market thoroughly so you can avoid as much risk as possible.
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Risk disclaimer: This article is for educational purposes only and is not investment advice. Trading indices through CFDs and other leveraged products carries a high risk of losing money rapidly because of leverage, and you can lose more than your initial deposit. Consider whether you understand how these products work and whether you can afford to take the high risk of losing your money. easytradeweb.com may earn a commission from broker links on this site at no extra cost to you.
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