Index trading is a common way through which traders are able to access financial global markets without directly investing in individual company stocks, bonds, commodities, or other assets.
Typically, the new players in financial markets begin their investment journey with index trading. This implies that they carry out trades using an index-tracking fund or a basket of shares, rather than choosing and trading individual company stocks.
A stock index tracks the performance of a large group of shares and provides the big picture of the market at large. This may be the stock market of a country or a particular sector which makes it clear that indices are usually diversified.
All of the leading financial markets around the world have one stock index that represents them. For instance, the S&P 500 (US500) represents the 500 largest companies in the US. Since these benchmark indices also generally show the stock market has been performing as a whole, any movement in the benchmark’s value can be considered a reflection of the economy or the sector it tracks.
Calculating stock market indices
Stock indices can be calculated in multiple ways on the basis of the kind of companies they track as well as the main index goals. While certain index calculations emphasize more on stocks that are priced high whereas others focus on market capitalisation. Of course, some also look at all constituent stocks equally.
- Price weighted
When we talk about price-weighted indices, the stocks are weighted with respect to the rate of the share and not the company’s size. This would imply that if a company has higher share prices, they would affect the value of the index more strongly. Price-weighted indices are not as prevalent as the ones that are market cap based.
- Market capitalisation-weighted
A market capitalisation weighted index ranks constituent companies on the basis of their value. Market cap is measured by multiplying a company’s stock price by the number of outstanding shares. Companies that have the largest market capitalisation would have a much larger influence over the index’s value.
Every company’s market cap is calculated on the basis of its free float shares that are made public for trading. A company’s free float market cap would typically be less than its overall market cap since it does not account for the shares held by company insiders.
An unweighted, or equal weight index treats all of its constituent companies equally and gives them the same weightage. This restricts one stock’s influence over the performance of the index which cuts down volatility but also lowers the effect of a sharp rally in a certain stock.
Types of indices
You will find several types of stock indices which cater to different needs of traders. These may be global, regional, national, exchange-based, industry, currency, and sentiment-based.
Note that besides stock index trading, it is also possible to trade commodity and bond indices.
A stock index can be calculated on the basis of the price of its constituent stocks. Every index lists down a set of criteria that a company should meet to be included in the index.
Benchmark stock market indices are usually mentioned in financial news reports. They’re believed to be signs that indicate confidence in business, performance and economic health.
Trading indices have been associated with particular industries and have also gained popularity among traders.
Indices which track commodities typically look at spot or futures contracts which indicate the price of a commodity, like crude oil, gold, silver, copper, coffee, and sugar.
You would also come across commodity-linked stock indices which represent stocks in companies that are associated in the commodity sector like mining companies or the ones which produce oil and gas.
Fixed-income securities which stand for a unit of debt are called bonds. When investors purchase bonds, they basically allow the bond-issuer to borrow money and they also charge an interest along with the repayments.
Bond indices have been created to measure how particular sectors perform in the market like corporate bonds, government bonds, and municipal bonds.
Currency-based indices track how an underlying currency performs. For instance, the US Dollar Index (DXY) calculates the greenback’s value against a basket of other currencies.
Sentiment-linked indices operate on the basis of market sentiments like volatility.
When VIX(Volatility Index) increases, volatility also rises which is associated with fear and sell-off in the market. On the other hand, a low VIX shows that the market is relatively stable.
How to trade indices
Keen to trade indices? Here are three popular ways in which traders can expose their portfolios to indexes.
If you are looking at predicting the moves in the short-term, cash indices are your best bet to trade an index intraday. The spreads in cash indices are much tighter than those in the futures markets. Additionally, they even continue to trade around the spot price and hence, the futures prices for the following month are also valued in a fair manner. Cash indices can undergo additional overnight charges as a result, traders typically close their market positions before the day ends.
Index futures and options
Trading index futures and options are better suited for the long run than cash products because of wider spreads. However, the overnight fees are still included. Index futures are derivative products created on the basis of the index’s expected future value. When the contract expires, it can be cash-settled or carried over to the next period.
Contracts for difference (CFDs) are yet another popular way one could predict the fluctuations in the index value. They’re essentially mutual agreements between a trader and a broker where the goal is to speculate on the difference in prices when a position is opened versus when it closes. If traders feel the prices would increase, they can open a long position, if they think the trades would fall, they may sell short.
CFDs are leveraged products where one can use borrowed funds and trade on margins so that there are better returns with just a nominal starting initial capital. Remember that CFDs for stock index trading can be risky since leverage can amplify both profit and loss. Visit multibank group