Unlike any other tradable asset class, indices give traders exposure to entire market sectors, rather than to individual companies or commodities. Indexes reflect the overall state of certain markets, as well as the economy as a whole, much more accurately than individual stocks.
Those who trade indexes need to consider macroeconomic data for their fundamental analysis. Geopolitical developments, the publication of sector-wide employment reports, as well as various economic reports fit this bill well.
What is an index?
An index represents a sort of basket or portfolio of stocks, which are considered to be representative of a certain market sector. The Dow Jones Industrial Average for instance, is made up of the stocks of the 30 largest US companies.
The evolution of an index reflects the average evolution of the stocks that comprise it. It does not really say anything about the evolution of individual stocks that make it up.
If the DJIA goes up 1% for instance, it means that the 30 stocks have gone up by an average of 1%.
Indexes are meant to offer a "bird's eye view" of certain market segments. This way, they simplify the overall picture, while taking into account all the essential details.
Most indexes represent a point based expression of the weighted average of the stocks that make them up. Each index is calculated in a slightly different way however.
How to Trade Indices?
You can trade indexes the same way you trade any other asset. Speculation is obviously the name of the game.
Buy an index if you have reasons to believe it will go up. Sell it if you think it will go down. Use a combination of technical and fundamental analysis (with extra focus on the fundamentals) to get your trading signals.
While the above is indeed the gist of the matter, there are a few peculiarities regarding indices trading.
Indices entail a peculiar type of volatility, which is rather intense, but limited in regards to volume. Because they are made up of several, independently evolving assets, indices tend to be quite volatile. They do not produce large swings however, usually staying within a 2 point/day range.
Violent economic events, such as market crashes, can elicit large volume swings.
As a trader of indices, you should keep an eye on the following factors:
- Index Listings. Over time, the makeup of indices can change, to properly reflect the state of the target market sector. Factors which can induce such changes are market capitalization, acquisitions and mergers.
- The correlation between country-specific indices and commodity prices.
- The correlation between indices and currencies.
- Market sector-related fundamentals.
Some popular indices:
- Dow Jones Industrial Average. Comprising the top 30 US companies, it represents around 25% of the US market.
- S&P 500. Uses the market capitalization of the top 500 US companies listed at NYSE, NASDAQ as well as CBOE BZX.
- FTSE 100. Includes the top UK companies, representing some 80% of the value of the London Stock Exchange.