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Indices Explained

Beginner

What are stock indices?

A stock index (the plural of “index” is “indices”) is the measure of the performance of a basket of equities over time.

Indices are an aggregation of the performance of the companies that are the constituents of that index. They are used as a gauge of performance for equity markets. Index products are a popular form of investment.

Indices are formulated by data providers such as FTSE (Financial Times Stock Exchange) or S&P (Standard & Poors). Over the years, the indices have become widely regarded as being the benchmark of the performance of stock markets for certain countries and regions.

  • S&P Global calculates indices all around the world, but the S&P 500 Index is regarded as the most important gauge of US equities, being the 500 largest listed companies in the US.
  • FTSE Russel is a global provider of benchmarking indices but is most famous for the FTSE 100 index, the UK’s leading 100 shares listed on the London Stock Exchange.

The different types of indices to trade

Many various indices are available. Here are the main types:

  • Country indices: These are the indices that cover entire countries or economies, such as the S&P 500 Index, the FTSE 100 Index or the Nikkei 225 Index.
  • Regional indices: These are indices that cover whole continents or economic areas, such as the STOXX 600 index (the 600 largest stocks in Europe), the FTSE Asia Pacific index or the FTSE Developed index.
  • Exchange indices: Some indices are designed to track stock exchanges. The NASDAQ indices cover stocks listed on the NASDAQ exchange (a specialised market for high growth and tech-focused stocks).
  • Sector indices: Some indices are available that focus on specific sectors, such as mining, banks or pharmaceuticals.

Ways to trade indices

Indices are a measure of the broad performance of equities. Instead of needing to trade several individual equities, it is now possible to also trade the entire index of the market.

Here are some of the ways that traders can be exposed to indices:

  • Index CFDs – The most simple and flexible way of trading indices is through a broker.

Brokers provide Contracts For Difference (CFDs) that track the performance of equity markets. The ability to go long (buy) or short (sell) gives flexibility in a trading strategy. Traders can take full advantage of stock market fluctuations.

Margin trading also allows greater exposure to market moves. Although this does also add to the risk of trading CFDs. There will also be the expense of overnight swaps to consider.

  • Index Funds and index ETFs – Index Funds and Exchange Traded Funds that focus on indices will track the performance of a stock market, region or sector.

Exchange Traded Funds (ETFs) of indices can be bought and sold on an exchange, just like equities. Index Funds are similar but can only be traded at the end of the day (once the fund has been recalculated). They are passively managed (the funds own every stock in the index) as the product subsequently looks to replicate the performance of the index.

Both funds come with “expense ratios” (i.e. annual management fees) which are taken out of the performance of the fund. Index Funds also often have minimum investment amounts, making them more restrictive for small account investors.

The pros and cons of trading indices

Here are a few pros and cons that need to be considered before trading indices.

Pros:

  • Add diversification – Indices allow a broader exposure to equities than individual stocks. Subsequently, they can help to improve portfolio diversification.
  • Reduce risk – Indices aggregate the moves of the whole basket of companies in the index. It means that the risks of owning any signal stock are reduced.
  • Trade in both directions – Whilst owning equities is the purest way of being exposed to stock markets, trading indices can be very flexible, especially through CFDs which allow short as well as long positions. This enables traders to potentially profit from declining prices.

Cons:

  • Volatility risk of trading on margin – Indices are an inherently lower-risk asset class than individual equities. However, trading indices on margin increases the level of risk and can incur significant losses if not managed properly.

Editor

Richard is an independent market analyst with over 20 years of experience working for brokers in London. Most recently he has worked with Hantec Markets and Infinox, focusing on trading education, ana... Continued

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