What do indices represent in financial markets? In general, an index is an indicator or measurement of something. In financial markets, indices trading consist of a hypothetical portfolio of stocks that represent a specific market or market sector. Most major and developing economies have at least one financial index. For example, the Dow Jones Industrial Average (DJIA), one of the most frequently used indices worldwide, consists of stocks from 30 of the largest companies in the US, representing approximately a quarter of the US market.
By comparison, the S&P 500 index is comprised of 500 of the most traded US companies and represents approximately 70% of the total financial value of the US stock markets.
Generally, the value of an index is represented by a number of points determined by a weighted average of the current values of its component stocks. When an index changes its value it directly reflects the fluctuating values of the individual stocks that it contains. This means that indices are usually representative of a country’s economic state. The same principle can be applied to a specific industry to determine its current value.
Understanding the stocks that make up an index
As different indexes are focused on certain types of stocks or market sectors, an effective way of analyzing an index is understanding its component stocks. Monitoring indices and their movements over time can inform traders about investors’ attitudes towards a certain range of companies or market sectors.
As an example, the NASDAQ index consists mostly of technology stocks, and thus can be used as a measure of the general state of the technology industry, although it also contains various stocks from other industries. Some of the most-widely traded indices include:
- S&P 500
- Dow Jones
How to trade indices
Trading on indices allows traders to speculate the movement of an index without buying shares in the underlying assets. In a sense, indices can be traded the same way as a currency, stock or commodity. For example, in order to make profit, the trader must sell an index at a higher price than its initial buy cost, or buy it back at a lower price than the trader sold it for.
All shares in an index contribute towards its overall value, with the index rising or falling in value depending on the performance of its stocks. This means that if investors are buying more than selling, the index value will go up, and if the reverse happens and more shares are being sold than bought, the index will decline.
Financial indices can be traded in two ways: “rolling daily” or “futures”. In the “rolling daily” trading format, the trades roll over from day to day. A trade in this form will stay open until the trader decides to close their position, or when their stop-loss or stop-limit is reached. New traders must know that the “rolling daily” trade format applies charges to a trade for each night the trade is open.
“Futures” format of trading means that there is a fixed expiry date and time at which their position will automatically close. This type of trading indices does not contain the overnight fees of the “rolling daily” trades.
Indices typically consist of a large number of stocks and the constant movement of share prices makes indices relatively volatile. Because it is highly uncommon for all the stocks in an index to experience major movements in the same direction at the same time, it is arguably safer to trade indices in comparison to equities.
Trading strategies for indices
Relevant markets and industries
Since the number of companies listed on an index can range from tens to thousands, it is wise to research and analyze the component parts on an index before trading. It is important to know if the index is comprised of shares from a wider range of industries or from shares that belong to a particular market or sector. This will help with better researching and understanding the impact of specific industries and domains on an index.
Changes to index listings
The stocks listed on an index can change due to factors such as mergers, acquisitions and market capitalization. It is worth keeping track of what stocks are removed and replaced from a certain index, as they will directly influence its market movement.
The correlation between indices and currencies or commodities
Some indices have a strong correlation with currency rates. This is usually the case with domestic indices, as the strength of the country’s currency will directly affect them. Studying the movement of currencies can be very important in predicting the future movement of indices. The same principle can be applied to commodities, as the value of certain currencies can change as commodity prices increase or decrease, setting trends that can be analyzed for better trading decisions.