There are several ways people can trade and invest in the stock market. One is by buying and selling individual stocks, and another popular way to do so is by buying trading indices.
With the stock market being one of the most profitable financial markets in the world, indices are powerful indicators, and having good knowledge of them will help develop strategies for trading in the stock market.
An index is a means to measure the performance of a group of assets which are publicly listed companies and their stock prices. This basket of assets or securities are grouped in a way that captures the entire market like the Dow Jones Industrial Average (DJIA) and the Standard & Poor’s 500 Index, or they can be put together in a way that reflects a particular industry or a segment of such industry. Some other well-known indices are the Nasdaq 100 Index, MSCI EAFE Index, Wilshire 5000 Total Market Index, and the Bloomberg US Aggregate Bond Index.
Indices are typically regarded as a benchmark for the stock market and bonds, and you cannot invest directly in them because it is an imaginary portfolio of assets. Each Index, such as the FTSE 100 has its method of calculation that shows you the performance of a group of securities.
Also, there are groups of securities referred to as mini indexes because they are smaller than a regular index, and a trader would require less money to trade in it. Trading with mini indices is a good way for traders to diversify their capital and invest in major companies with less capital which in turn reduces the risk they face.
Indices trading or index trading refers to buying and selling of a stock market index. Here traders try to make profits by speculating the movement of a specific index to determine whether they are buying or selling it. Since an index does not contain any actual stock but serves as a benchmark to measure the performance of a group of stocks, a trader doesn’t buy any underlying stock but the performance of the group of stocks.
This means that when the price of stocks in an index goes up, the value of the index rises, and if the price of the shares falls, then the value of the index will also fall. While traders can focus their efforts by trading on one index, they are not restricted to it as they can trade multiple indices as part of a wider strategy.
For indices trading, some of the most traded markets are:
- Dow Jones: This is an index that contains 30 blue-chip stocks from some of the biggest publicly owned companies in the US
- The DAX: This index comprises the shares of 40 German companies, and it is usually regarded as ‘Germany 40.’
- The FTSE 100: This represents the stocks of 100 of the biggest companies in the UK, and it is sometimes referred to as ‘UK 100.’
- NASDAQ 100: This capitalization-weighted index focuses on over 100 of tech companies in the US.
- CAC 40: This represents the stock prices of 40 of the biggest companies in France, and as a result, it is referred to as ‘France 40.’
- Nikkei 225: This is the biggest price-weighted index in Japan, and it comprises shares from 225 of the biggest companies in the country.
Pros and Cons of Indices Trading
Are you looking into the differences between trading forex vs indices and wondered how indices trading stacks up against forex? Here are some of the reasons why indices trading is popular among investors and traders.
Lower risk than trading individual stocks
Indices trading has a relatively lower risk than trading individual stocks because you are betting on the performance of a basket of stocks of companies instead of a particular stock. However, like with any asset, indices trading still has a level of volatility due to several unexpected factors, which is why every trader should maintain a degree of caution when trading indices.
Diversification from the start
An index contains stocks from different publicly-traded companies, which allows you to trade based on the combined performance of different shares. For instance trading on NASDAQ 100 allows you to diversify your capital among 100 tech companies in the US. In addition, you are not restricted to one index but can trade with multiple indices at the same time or trade with mini indices depending on your capital.
Easy means of determining the health of the stock market or a specific industry
Depending on the index, a trader can easily determine the current state of the market. For instance, stocks that belong to the same industry, like tech, typically move in the same direction, which lets you know what’s going on in that industry, i.e., bullish or bearish.
Moreover, some of these indexes, like the Dow Jones have been around for a while which gives investors and traders access to historical data that will provide some help in understanding how the market has reacted to certain unexpected situations in the past and make better decisions based on it.
Less research is required
Investing and trading individual stocks requires a comprehensive knowledge of the activities of a specific company. This is not needed when trading indices as all that is required is good knowledge of the economy of the stock market or the industry in question. If a trader believes that a particular industry is doing well or will experience significant growth, they can bet on its related index instead of having to dig deeper into the history of the companies that make up the index.
The main downside of indices trading is that companies with higher stock prices and market capitalizations have a huge impact on the movement of the indices. This is because most indices give more regard to companies with higher market caps and stock prices and little exposure to small-cap companies. In addition, indexes such as the Dow Jones Industrial Average Index have been criticized to only represent blue-chip companies which are a small fraction of the stock market.
To begin indexes trading, you should:
Step 1: Find an index you are interested in
There are several indices available like the Dow Jones index and the first thing every trader should do is decide which index they will be trading. This could be due to interest or having sound knowledge of the industry that the index relates to. Remember that you can choose more than one index.
If you don’t have prior knowledge of any index, you can always do more research about the opportunities available in the different indices and which is the best fit for you.
Step 2: Choose your trading method
After establishing the index you wish to trade in, the next step is to determine your method of trading. There are two main ways of trading indices and each trading method has its characteristics. There are two major ways indices can be traded. The first is by CFDs (Contract on Difference) which means that traders trade on the price movement of the index without owning any of the assets. Here, a trader makes a profit based on the difference between the opening and closing trade prices of an index.
The second means is through spread betting. Here, traders are allowed to bet on the movement of an index. Where the index moves towards your direction, you make a profit and if it doesn’t, then it results in losses. Spread betting is usually touted as a commission-free and tax-free venture as all costs are covered by the difference between the buy and selling prices.
The method you choose can affect your decisions and trading strategy.
Step 3: Do your research before trading
It is necessary to do your analysis of the market to identify trading opportunities before placing a trade. You can profit from both falling and rising markets as long as you can decide which direction would be most profitable. Some technical analysis tools you can use for conducting research are:
- Trend Indicators to determine the direction that the market is heading. Indicators like Moving Average Convergence Divergence (MACD), Parabolic SAR, Bollinger Bands, and Simple Moving Average can be used as trend indicators.
- Volatility indicators can help analyze how much the price of an index will change within a period of time. However, it only gives you an idea of the price and not the direction that the index will take.
- Volume Indicators like Acceleration Bands, On-Balance-Volume, and Market Facilitation Index can show you the amount of trading in an index and how it has changed. Volume indicators can provide useful information regarding how strong the next movement of the index will be which can influence trading decisions.
Step 4: Employ risk management tools
After completing your research, the next step is to place a trade and it’s crucial that you have risk management tools in place when doing that. Like any financial market, there is a level of risk inherent in every trade and it is important to protect yourself from potential losses and risks you are not comfortable with. Trade according to your budget and use tools like stop-loss orders to protect yourself as soon as you begin trading.
Trading indices is a good way to make a profit based on speculating on the performance of the market without having to put in as much work as trading individual stocks or forex. However, take your time to study the market and how accessible it is to you based on your trading platform.