For investors, an index is a measure of the performance of the price of stocks, bonds or other tradable assets in the wider securities market. When you hear newscasters talk about the ups and downs of “the Dow,” they are talking about how well a specific index — the Dow Jones Industrial Average — performed that day. Experienced traders are aware of the main US, European, and Asian stock indexes and while most traders have likely heard of or monitor these indexes, many new traders don't know how the stock indexes are traded. In this article, you will learn what is a stock index and how are traded.
- What is a Stock Index
- How a Stock Index Works
- Advantages of Trading Stock Indexes
- How to Trade Stock Indexes
What is a Stock Index
A stock index is a compilation of stocks constructed in such a manner to track a particular market, sector, commodity, currency, bond, or another asset. For example, the NDX is an index that tracks the largest 100 non-financial companies listed on the NASDAQ.
The SET50 and SET100 Indices are the primary stock indices of Thailand. The constituents of both lists are companies listed on the Stock Exchange of Thailand (SET).
Or, for example, a technology stock index will contain several or all technology stocks. The index then moves with the overall performance of the stocks that it holds within it. This index can then be quickly used to monitor how technology stocks are performing currently and over time.
Indexes are popular because they provide information for a basket of stocks, and not just one. Therefore, they are good analysis tool, as well a good trading tool as we'll see in the next sections.
Foreign Stock Index examples:
- The S&P 500: As noted above, Standard & Poor’s 500 is an index of performance of the 500 largest U.S. public companies.
- The Dow Jones Industrial Average: This well-known index (also known as the DJIA) tracks the 30 largest U.S. firms.
- Nasdaq: The Nasdaq Composite tracks more than 3,000 technology-related companies.
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Continue reading or start playing around in a risk-free demo account and trade the most popular stock indices in real market conditions with virtual funds.
How a Stock Index Works
Indexes are designed to track a particular market or asset. The stocks in an index are collected in what’s known as a basket. For example, if you wanted to invest in the Dow Jones Industrial Average Index (DIJA), you would purchase shares of the 30 stocks in the index basket. You would actually own shares of 30 different companies.
Index-weighting is how the shares in an index basket are allocated; basically how the index is designed. For example, a price-weighted index has different amounts of shares for each stock based on price. A stock worth $20 would have 1 share, where a stock worth $5 would have 4 shares to make it equal to the $20 stock.
Another type of weighting is based on market capitalization. The shares of each stock in a cap-weighted index are based on the market value of the outstanding shares. There are also revenue-weighted indexes, fundamentally-weighted indexes, and even float-adjusted indexes.
Key things to know about stock indices
- They’re an indirect way to buy the whole market. Indexes are designed to track a particular market or asset.
- By accepting defeat, you actually win. Picking individual stocks, you’re probably not going to outperform the market.
- Stock Indexes are increasingly popular with investors. Most of the hedge-fund managers include stock indexes in their portfolio.
- Stock Indexes are available across a variety of asset classes. Investors can trade indexes that focus on companies with small, medium or large capital values or focus on a sector like technology or energy.
Advantages of Trading a Stock Index
Indexes are a nice way to gain exposure to certain markets or sectors without having to corner the market in stocks. You can gain exposure to the overall performance of a market or sector or subsector by buying the appropriate index basket.
- Individual stocks may rise and fall, but indexes tend to rise over time. With stock index, you won’t get bull returns during a bear market. But you won’t lose cash in a single investment that sinks as the market turns skyward, either. And the S&P 500 has posted an average annual return of nearly 10% since 1928.
- Stock Index have fewer fees that erode your returns. The trading costs are lower for indexes since they require less work than managed accounts. You’re not paying for someone to study financial statements and make calls on what to buy.
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- The stock indexes help diversify your portfolio. Stock Indexes spread risk around and give investors greater choice among conservative and riskier investments, as well as a broader mix of industries and asset classes. Trading indices, you simply don’t put all your eggs into one basket.
- Lower risks. Though indices can also be volatile due to factors like geopolitical events, economic forecasts, and natural disasters, an index losing or gaining 10% is already a huge historical event that will often hit the news.
- No risk of bankruptcy. Unlike an individual company, an index can’t go bankrupt. If a DAX 30 constituent goes bankrupt, it is replaced by the 31st company in the list of leading German companies. However, if you hold shares in this business, you’ll automatically lose your investment.
How to trade Stock Indexes
The stock indexes cannot be traded directly, and are available for information only (as a way to track the performance of a group of stocks). Market data is available for the stock indexes, and they can be charted like any other market, but there is no way to make either a long or short trade on the actual stock indexes. But other financial products, like index funds and contracts for difference (CFDs), can be used to trade the movements of stock indexes.
1. Trading Stock Index CFD
A contract for difference (CFD) is a type of contract between a trader and a broker in order to try and profit from the price difference between opening and closing the trade.
Using CFDs to trade indices will allow you to go long or short the market without having to deal with conventional exchanges. You trade direct with your CFD broker. No matter whether you have a positive or negative view of the index forecast and predictions, you can try to profit from either the upward or downward future price movements.
Made up of a wide cross-section of liquid trading instruments, indices are extremely popular with CFD traders around the world.
Advantages of trading CFDs
With an increasing number of traders choosing CFDs as their favorite financial instrument to trade the global financial markets, let’s take a look at the benefits of CFDs, as opposed to traditional investing.
If you are familiar with traditional investing, you will know that traders are limited in their ability to profit from their predictions in the sense that you cannot sell a share that you have not bought before. That’s where CFDs come into play. CFDs allow traders to profit both on rising and falling price movements, simply because with CFDs you do not essentially own the underlying market.
The second clear benefit of CFDs is the opportunity to trade on margin, also known as leverage. This means, that if a trader wants to control a position on DAX worth £2,000 and the margin requirement of the broker is 5%, then he will only need £100 to open the trade. It is important to note here that in a profitable scenario, profits are calculated on the full-size position. However, losses follow the same calculation too. That’s why traders should use caution when trading on margin.
One of the most popular ways to use CFDs is for hedging positions. Let’s suppose that you have bought a share, the price is pushing lower and your profit and loss is in red territory. In this scenario, opening a short CFD position on the share allows you to limit your losses, as the short position will be gaining value should the market continue moving lower.
Structuring the size of your position according to your risk profile is key for long-term profitability in trading. For that reason, when starting with CFDs it is important to choose a broker who offers variable contract sizes. In that way, less experienced traders can begin with mini contracts and lower exposure to the markets, whereas seasoned traders can still trade in larger volumes.
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Example of Trading Stock Index CFD
CFDs were initially designed for shares trading. With their popularity growing over the years, CFDs are now used to trade a wide range of markets including indices, energies, and commodities. In CFD trading, there are two prices: the buy and the sell price. The difference between the two is called the spread. By trading at the buy price, you will profit if the asset’s value increases. By trading at the sell price, you will profit if the asset’s value decreases. Let’s take a look at some trading examples to find out how CFD trading works in practice.
CFD trading examples
Let’s suppose that market rumors for the German banking sector suggest that the DAX is about to take a hitting. For that reason, you decide to go short (sell) 5 contracts of DAX30 at the price of 13,050, which equals to €5 per point movement.
Your prediction proves to be right and the market pushes lower to 12,946. You decide to exit the trade and secure your gains. The total profit is (13,050 – 12,946) x €5 = €520.
Despite the rumors, the market keeps pushing higher above 13,100. At this point, you decide to close the position at 13,089 in order to avoid bigger losses. The total loss is (13,123 – 13,050) x €5 = €-365.
Now let’s take a look at how a long trade would look like. The S&P500 is trading at 2,601, your technical analysis gives you a buy signal and you decide to go long 3 contracts. In this market, 3 contracts equal to $30 for each point movement.
Five minutes before market close, the market price has moved higher to 2,619 and you decide to materialize your profit, rather than risk an overnight move against you. Your total profit is (2,619 – 2,601) x $30 = $540.
During the US session, some unexpected breaking news pushes the index lower and the market price is now at 2,588. You decide to cut your losses and exit the trade. Your final loss is (2,601 – 2,588) x $30 = $-390.
Although the profit and loss are calculated in the currency of the asset class, there is no reason to worry. An AM Broker account automatically calculates your profit and loss into your account’s currency in real-time based on the exchange rate.
2. Trading Stock Index Funds (ETFs)
An index fund is a type of mutual fund whose holdings match or track a particular market index. It’s hands-off, and you could build a diversified portfolio earning solid returns using mostly this type of investment.
That’s because index funds don’t try to beat the market, or earn higher returns compared with market averages. Instead, these funds try to be the market — buying stocks of every firm listed on an index to mirror the performance of the index as a whole.
Index funds can help balance the risk in an investor’s portfolio, as market swings tend to be less volatile across an index compared with individual stocks.
Benefits of trading Index Funds:
They pool money from multiple investors to buy the individual stocks, bonds or securities that make up a particular market index
They are a good way to minimize risk because they track a market index, which generally rises in value over time
They’re a passive investment with lower fees than mutual funds managed daily by professional brokers — and they often show better returns
Their potential gains and losses are less volatile than those of managed funds that try to beat the market
Top Index Funds to Buy:
- Vanguard S&P 500 ETF
- SPDR S&P 500 ETF Trust
- iShares Core S&P 500 ETF
- SPDR Dow Jones Industrial Average Trust ETF
- SPDR Gold Shares ETF
- iShares Silver Trust ETF
>> How to Buy an ETF in less than 1 hour
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