Trading Indices

From binary options and CFDs through to specialist funds, whatever your trading instrument of choice, you’ll find no shortage of products linked to the performance of a specific asset index, such as the FTSE, DAX, or S&P500.

So what exactly is an index? How does it work? What should you bear in mind when taking a position on indices compared to stocks, commodities and other types of underlying assets? In this tutorial we explain how and where to get involved with index trading.

Indices Explained: What Are They For?

A stock index comprises a list of a defined number of securities (i.e. publicly listed companies along with their share prices)

They are selected on the basis of the criteria laid out by the creators of that index. In theory therefore, anyone can draw up an index – although if you happen to also edit The Financial Times, or be a global credit ratings agency (like Standard and Poor’s), your “list” is going to get a lot more exposure and credence than that of the man in the street.

Dow Index

The original and still the best known index was created by Mr. Charles Dow back at the end of the 19th Century. Known as the Dow Index, it listed the 12 largest public companies in the U.S. Its predecessor lives on as the Dow Jones Industrial Average or ‘US30’; containing the likes of Apple, Boeing and Procter & Gamble, it comprises the 30 largest companies traded on the New York Stock Exchange and the Nasdaq.

A Quick Barometer

The rationale behind Mr Dow’s original list still applies to virtually all indices today. First and foremost, they are designed to give a snapshot of a particular economy. Because each index has its own specific inclusion rules, comparing one index with another can also be useful for drilling down information about different segments of that economy.

Take Brexit for instance: after the vote, the FTSE 100 index recovered rapidly after its initial downward spike. But the FTSE 100 Index comprises the 100 companies listed on the London Stock Exchange with the highest market capitalisation. These are essentially huge internationals and their rapid bounce back wasn’t necessarily seen as a sign that ‘UK plc’ was taking Brexit in its stride.

By contrast, the FTSE 250 consists of the 101st to the 350th largest companies listed on the Exchange. This Index took markedly longer to return to pre-vote levels, but because the companies on it tend to be much more domestically focused, it was seen as a much more reliable proxy for gauging how the economy was coping with the fallout of the vote.

A ‘Who’s Who’ of shares to watch

In March 2017, we saw Capita and Dixons Carphone demoted from the FTSE 100 – to be replaced by Rentokil and the investment trust, Scottish Mortgage. It highlights that as well as providing a barometer of the health of the economy as a whole, indices perform a further function: they flag up noteworthy or top performing shares for investors.

Index-linked investment products and trading instruments are widely available. As well as being able to invest in funds designed to mirror the composition of particular indices, you’ll also find options, CFDs, spread betting and futures instruments all geared around indices.

Top Indices

Which indices are you most likely to come across when trading? Here’s a rundown of some of the most popular…

The Dow Jones

The Dow Jones Index. 30 major US companies on the New York Stock Exchange and NASDAQ.

S&P 500

Standard & Poor’s (S&P) 500. 500 large cap American companies, which, combined, cover approximately 75% of the American equity market.

FTSE 100

The 100 companies with the highest market capitalisation on the London Stock Exchange.

DAX 30

The DAX consists of the 30 highest cap companies listed on the Frankfurt Stock Exchange.

Nikkei 225

The benchmark index for the Tokyo Stock Exchange.

Hang Seng Index.

The index for Hong Kong. In addition to the benchmark HKG33 index, there are also four sub-indices for distinct sectors, each with 50 constituent stocks, covering finance, utilities, properties and commerce & industry.

How Indices Are Calculated

How a particular index is calculated all depends on the method of “weighting” used. Most indices are worked out on the basis of market capitalisation. This refers to the total market value of a company’s outstanding shares.

So if a particular company is valued at £1,000,000 and the value of all stocks in the index is £100,000,000, then that particular company would be worth 1% of that index.

Some indices (the Dow Jones Industrial Average being one example) use a price-based weighting system. Here, the weight of a stock in the index is determined by share price relative to the sum of all share prices in the index. It means that a £1 price change in an expensive stock effectively has the same effect as a £1 price change for a lower-priced stock.

Trading Indices: Special Considerations

It’s not necessarily the case that indices are inherently more or less risky than stocks or other assets. Rather, different considerations are at play. Typically, these can include the following:

• Geopolitical and market factors. Indices require you to take a macro view. In other words, what’s happening in the wider economy that might help or hinder the ability of the companies included on the index to operate successfully?
• Market-wide data releases. These include consumer and business confidence surveys, employment statistics and industry-specific forecasts. Again, this is the type of data that affects companies across the board.

Generally, index-linked trading instruments and investment products appeal to a certain type of trader. You still have to do your homework in terms of analysis – but the type of information tends to be widely drawn.

There is less emphasis on the internal workings of individual companies – and more on nation-specific and global economics. That said, a major development at, say, the likes of General Electric or Apple is likely to be felt across the relevant index. But if you tend to prefer market fundamentals to internal company politics, trading indices can make a lot of sense.

Does your broker provide the right risk management tools for effective index trading? The volatility of indices means opportunities – as well as risks for traders. Browse our unbiased broker reviews to ensure you get the support you need.