An index tracks the performance of a group of securities or assets, based on predefined characteristics and features. Indices can be organised around industry, geographical region, market capitalisation, growth rate, etc. They can also be grouped according to asset type, such as stocks, commodities or metals. Index trading, then, is the buying and selling of financial instruments linked to indices. This can be an alternative way to gain exposure to market opportunities across groups of assets rather than individual securities.
What affects the price of indices?
Indices are priced based on the securities they represent. Thus, as the underlying stocks or assets move up or down, so will the price of the index. Since indices tend to include a large number of securities, price movements in any individual asset will have limited impact on the overall price. Instead, indices tend to reflect investor sentiment of broader market conditions, rather than individual companies or assets. Indeed, some high-profile indices such as S&P500 or are used as macroeconomic benchmarks, such as indicators of bull or bear markets.
As an index covers a basket of different assets, it is inherently more diversified than singular securities or equities, which renders it an effective way to increase portfolio diversification.
Some factors that affect index prices include:
- Market downturns: During a recession, stock prices will inevitably fall. This will also cause the prices of the equity indices to drop.
- Interest rates: Interest rate hikes increase the cost of debt, which can in turn, lower demand in the stock market – which is reflected as lowered market index levels.
- Inflation: If inflation goes too high, investors may invest less or sell their holdings to fund living expenses. This may cause stock markets – and market indices – to fall.
- Geopolitical events: Market indices can be impacted by geopolitical events, such as favourable election results, or cessation of war and hostilities between nations. If the market gets buoyed by positive developments, market indices, too, will be uplifted.
Top 5 indices investors should know
If you’re looking to trade indices, a good place to start would be with some of the world’s most referenced indices.
- S&P 500. The Standard & Poor’s 500 Index (S&P 500) is perhaps the most well-known market index. It tracks the performance of the largest 500 companies in the world that are listed on U.S. stock exchanges. The S&P 500 is often used as a gauge of whether the market is in a downturn or upswing – movements of 20% is the often-cited threshold.
- NASDAQ 100. Another popular market index, the NASDAQ 100 tracks the top 100 U.S. companies trading on the Nasqaq stock exchange. Because most of this index’s constituents are tech companies, the NASDAQ is often taken as a stand-in for the overall tech sector.
- FTSE 100. If you’re looking for U.K. stocks instead, the FTSE 100 tracks the 100 largest companies listed on the London Stock Exchange. It is also known as the “Footsie”.
- Nikkei 225. For exposure to Asian equities, consider the Nikkei 225. This Japan-based index tracks the performance of the top 225 Japanese companies listed on the Tokyo Stock Exchange.
- Dow Jones Industrial Average. Also known as the “Dow Jones” or the “Dow”, this is among the oldest market indices in the world. It tracks 30 of the most prominent companies listed on U.S. stock exchanges and is a leading benchmark of the equities market.
Trading indices using CFDs
Since indices only track – but do not hold – any tradable securities, trading indices can only be carried out using Exchange Traded Funds (ETFs) or CFDs. For ETFs, this simply means purchasing shares of a fund that tracks an underlying fund; one such example is the SPDR S&P 500 ETF Trust (SPY), which attempts to track the S&P 500. The value of your holdings will rise or fall in accordance with the S&P 500’s movements,
Another way to trade indices is with Contracts for Difference (CFDs), which are financial derivatives that allow investors to speculate on the price movement of an underlying market index.
CFDs are an advanced trading strategy that takes the form of an agreement between an investor and a trading brokerage. Both parties agree to exchange the difference in the value of an index between the time the contract opens and closes. Hence, if you expect the price of an index to go up, you can open a long position. Alternatively, you can open a short position if you expect the price to come down. Note that CFDs are leveraged products that allow you to trade on margin. Care should be taken as trading using margin will amplify your profits or losses.
Pros of trading index CFDs
Trading index CFDs can confer several benefits, such as:
- Lower capital upfront: CFDs can be traded on margin, which means investors can open a larger position with a smaller capital upfront. This allows CFDs to be traded even by those with small starting capital.
- Leveraged trading: When using CFDs to trade indices, an investor can choose to use leverage. This will amplify the outcome of the trade, whether it be a profit or a loss.
- Trade in any direction: As explained above, trading indices using CFDs makes it possible to use both long and short positions. This increases the potential for profit, provided the trade goes in the right direction.
Cons of trading index CFDs
Index trading using CFDs is, of course, not without its downsides. These include:
- Higher risk: CFD index trading involves a higher level of risk compared to trading shares of an index ETF. In adverse scenarios, your losses might surpass 100% of your initial investment. In contrast, when you exclusively buy shares of an index ETF, your potential loss is limited to the amount you invested.
- Improper use of margin: Arm yourself with discipline and sound knowledge. Failing to grasp margin management can quickly lead to significant losses.
- Not suitable for beginners: Achieving success in trading Indices using CFDs demands a considerable amount of knowledge and experience. Novices should contemplate exploring alternative methods of indices trading until they have a solid understanding of the subject.
Tips for index trading
- Stay on top of the market. As indices are affected by market developments, it’s crucial to stay on top of geopolitical news and other macroeconomic events. Doing so can help you get ready for trend reversals and other trading opportunities.
- Learn technical analysis. Being able to interpret a price chart is important when trading indices. Besides price action, you should also learn how to use chart patterns, indicators and other tools to help you make educated guesses that can increase your success rate.
- Select indices that suit you. There are a great many indices out there, each tracking different groups of assets and securities. You should select indices that align with your interests and preferences. For instance, if you are highly keen on tech companies, chances are you are already keyed into important developments and new trends in that sector. Hence, you may be familiar and comfortable trading a tech-focused index, such as the NASDAQ 100.
Conclusion
Trading indices can be a rewarding way to gain exposure to different types of asset classes and baskets of securities, without having to keep track of individual stocks or commodities. You can also gain a greater degree of diversification with indices, compared to regular stocks. Advanced investors can also trade indices using CFDs to seize market opportunities regardless of market conditions.
FAQs on index trading
- Q1. What is indices trading? A: Indices trading is the buying and selling of financial instruments linked to market indices. As a market index is simply a reading, and does not hold any assets, investors will need to use an index ETF or CFD to trade indices.
- Q2. What are some of the top market indices? A: Some of the most widely known indices include: S&P 500, which tracks the top 500 companies listed on U.S. stock exchanges; FTSE 100, which tracks the 100 largest companies listed in London; and the Nikkei 225, which tracks the top 225 Japanese companies on the Tokyo mainboard.
- Q3. What are some of the factors that affect the prices of indices? A: Strictly speaking, market indices do not have prices. However, their readings or levels go up or down in reflection of the stock prices of the companies they track. As such, market indices are affected by market downturns, inflation, interest rate hikes and geopolitical events.
- Q4. What are the pros and cons of trading indices using CFDs? A: The advantages of trading indices via CFDs comprise lower initial capital requirements, the capability to engage in leveraged trades, and the potential to seize trading opportunities in various market directions. Conversely, the disadvantages of trading indices using CFDs involve elevated risks dude to the use of leverage, and limited suitability for beginners.
- Q5. What are some tips for indices trading? A. If an investor intends to trade indices, it’s crucial to consistently stay informed about market news and events, as well as selecting indices that align with one’s interests and preferences. Learning technical analysis can also prove valuable in spotting potential trading opportunities.
