An index (plural, indices) is a measure of a collection of assets or tradable securities. It aggregates the prices of all the underlying assets and provides a single value representing them. In this way, indices act as an “average reading” of particular market segments or asset classes, and thus function as a handy benchmark of the grouping they represent. Today, there are many indices in use, and some of the most prominent ones are stock market indices that describe the state of different markets.
One example is the S&P 500, which tracks the collective performance of the 500 largest companies listed on the U.S. stock exchanges. Another is the Dow Jones Industrial Average – probably one of the longest-running stock indices out there – that tracks 30 of the most successful companies listed in the U.S.
Different countries and/or geographical regions have their own stock market indices too. For instance, the FTSE 100 is a listing of the biggest 100 companies listed in London, while the Nikkei 225 tracks the top 225 companies listed in Tokyo, while in Singapore, the Straits Times Index tracks the 30 largest and most liquid companies listed on the Singapore Stock Exchange.
How are indices calculated?
The method used to calculate an index depends on the type of assets being tracked, as well as the goal of the index. Two of the most common methods of calculation are price-weighted and market capitalisation-weighted. Some indices may also choose to use an unweighted calculation.
- Price-weighted. In a price-weighted index, the individual prices of the underlying securities determine their weighting in the index. This means that higher priced assets are weighted more heavily than lower priced ones. Thus, in a price-weight index, higher priced assets have a greater impact on the movement of the index. Some examples of price-weighted indices include the Nikkei 225 and the Dow Jones Industrial Average.
- Market capitalisation-weighted. Many stock market Indices are market capitalisation-weighted. In these indices, the market capitalization – share price multiplied by number of shares – of the underlying companies is what determines their weighting in the index. Hence, such indices are more heavily influenced by price movements in the largest tracked companies, while aggressive price movements by smaller companies have lesser impact. Indices that are market capitalisation-weighted include the S&P 500, FTSE 100 and the NASDAQ Composite Index.
- Unweighted. An index that is unweighted gives equal weighting to all of its constituents. The price of the index is simply calculated using a simple average. This has a dampening effect on volatility, as the influence of any one particular underlying stock or asset is limited. One example of an unweighted index is the S&P 500 Equal Weight Index, where all underlying assets are periodically balanced to take up no more than 0.2% of the total investment amount. This index is a viable alternative for those wishing to trade the top companies but with more price stability.
Why trade indices?
There are several compelling reasons to trade indices, such as:
- Lesser volatility: As indices are composed of several securities, they are comparatively less volatile than investing in just a few stocks. However, there may be exceptions, such as indices that track aggressive, high-growth companies.
- Diversification: Since indices contain several constituents, they offer diversification by default. Investors can use indices as an easy and proven way to diversify their own portfolios.
- Long-term growth: Stock market indices are periodically rebalanced to track the top performing companies, leading to steady growth – especially over the long term. For an example, look no further than the S&P 500.
- Potential profit in both directions: Investors who trade indices can potentially profit from both market upswings and downtrends. This makes index trading a good strategy for those looking for opportunities in all market conditions.
At Vantage, you can trade indices using indices Contract for Differences (CFDs), where you trade the rise and fall of indices prices, without having to actually own the index. With CFDs you can also trade with leverage, allowing you to execute larger trades even with limited capital.
The pros and cons of trading indices CFDs
| Pros | Cons |
| Lesser volatility than individual assets or securities | Lower upside potential, as individual price movements of constituent stocks are averaged out |
| Greater diversification within each index, making it potentially less risky than building own portfolio | No control over underlying assets or how they are weighted |
| Potential profitability in bull and bear markets | Lack of downside protection, as losses are not capped unless there is a stop-loss in place |
| Traders are able to trade using leverage, allowing execution of larger trades with limited capital. However, leverage involves inherent risks of amplifying potential losses. |
How to trade indices?
An index is simply a measurement and doesn’t actually hold any of the underlying assets. Thus, index trading is performed via different financial instruments, such as Exchange Traded Funds (ETFs) or index funds. You can buy and sell shares of ETFs or index ETFs that track the index you want to trade. You can also trade indices via CFDs. A CFD is a contract between an investor and a brokerage to exchange the difference in the price of an index between the time the contract opens and closes. CFD Indices trading requires a degree of knowledge and skill, which is better suited for seasoned traders.
Example of index trading using CFDs
The following example illustrates how index trading using CFDs works. Let’s set up a hypothetical CFD trade with Index ABC, which currently has a bid/ask price of 5000/5002. We’re following a long strategy in this scenario, but note that CFDs also allow you to take a short position if you’re bearish about the index. To begin the trade, you decide to open a long position, as follows:
- Index ABC
- Ask price: 5002
- Number of CFDs: 2
- Capital required: USD 10,004
- Margin requirement at 5%: USD 500.20
Scenario 1: Index ABC moves up
Index ABC makes a 30-point move to the upside, giving you a winning trade. You decide to close your position and take the profit. Each one-point move equates to USD 1 per contract. Hence, the 30-point move in Index ABC gives you a profit of USD 1 x 2 x 30 = USD 60. A profit of USD 60 over an initial investment of USD 500.20 = 11.99% ROI for the trade.
Scenario 2: Index ABC goes down
Let’s assume this time that the trade goes against you; Index ABC enters a downtrend, and you decide to close your position to cut your losses. At closing, the index has fallen by 25 points. Once more, since 1 point equals to USD 1, your total loss on the trade is USD 1 x 2 x 25 = USD 50.
Tips for trading indices via CFDs
- Pay attention to index weighting. As discussed above, many popular indices are composed using weighted averages. This means that it is not uncommon for the top 10 or so stocks to move the entire index. Be sure to understand how the index you want to trade is weighted (by market cap or share price) and pay attention to the relevant underlying companies. This will help you better anticipate the index’s price trends.
- Be familiar with technical analysis. As index trading requires paying close attention to price action, it is a good idea to pick up some basic technical analysis skills, such as knowing how to use the right technical indicators to confirm expected price moves stemming from incoming events or developments.
Conclusion
Index trading offers many advantages. Investors can gain exposure to several different companies or securities at once, grouped based on predefined criteria like large-cap companies. This eliminates the need to individually monitor stocks or securities, while benefiting from greater diversification.
Trading indices using CFDs provides investors with a more flexible and powerful tool to seize market opportunities regardless of market direction. With its margin facilities, advanced investors can take larger positions with smaller upfront capital. However, it’s crucial to exercise prudent leverage management to mitigate the risk of margin closeouts.
