An Index (plural Indices) is a grouping of assets together to measure the performance of a financial market or specific area within a market. Indices are one of the most commonly referred to economic indicators within the world of finance. Even the completely uninitiated are aware of Indices such as the Dow Jones or the S&P.
So what is their purpose and, more importantly, how can they be traded for profit? The first part of the question is relatively simple. Indices provide a snapshot of a market that can show whether that particular market is growing or shrinking. They can be used to guide economic decisions such as whether to raise a country’s interest rates, to provide import/export incentives, or to invest in a specific industry. While their primary purpose is as a method of measurement, they have also become an instrument that can be used for trade.
SOME COMMON INDICES
You are likely to have heard of the Dow Jones, the Nasdaq, and the S&P. Depending on the country you live in you may be familiar with the FTSE, Nikkei, DAX, or the ASX. You are far less likely to have heard of the Wilshire or the BarCap Aggregate. Knowing about these smaller indices can be useful market information for a trader. Although, it is unlikely that you will be able to find a broker that allows you to trade in them.
Focusing on the major indices we have:
The Dow Jones Industrial Average:
The Dow Jones is a price-weighted index, meaning a stock trading at $100 makes up 10 times more of the index than a stock trading at $10. It includes 30 prominent companies listed on various US stock exchanges as selected by a committee. Due to it only including 30 companies, the movement of a single company has the most impact on the Dow Jones. This does not necessarily make the Dow Jones volatile given the stability of the companies contained in the index.
The Nasdaq 100
The Nasdaq 100 is a modified capitalization-weighted index, meaning each company within the index is weighted by it’s market capitalization with restrictions to limit the influence of the largest companies. Market capitalization is merely the number of shares owned by a company’s shareholders multiplied by the value of those shares. The Nasdaq 100 consists of the largest companies listed on the Nasdaq stock exchange selected each year in December. The Nasdaq 100 is considered to be an indicator of the technology industry as it is limited to non-financial entities. Given that it is focused so heavily on technology stock the Nasdaq is considered to be the most volatile index.
The Standard and Poor’s 500
The S&P 500 is a free float capitalization weighted index. This is the same as a capitalization weighted index except that market capitalization is restricted to only those shares readily available in the market. The components of the S&P 500, like the Dow Jones, are selected by committee. Unlike the Dow Jones, the S&P consists of 500 US stocks trading on the New York Stock Exchange (NYSE) and the Nasdaq.
The Dow Jones, S&P, and Nasdaq all perform similarly to one another as there is quite a bit of overlap. Currently all of the companies in the Dow Jones are listed in the S&Ps, as are over three quarters of Nasdaq 100 stocks. A few stocks (7 at the time of writing) appear in all three indices; Amgen, Apple, Cisco Systems, Honeywell International, Intel Corporation, Microsoft Corporation, and Walgreens Boots Alliance.
TRADING AN INDEX
The first thing to recognize when trading an index is that you are not buying or selling a tangible thing. Trading in indices has more in common with gambling than it does with buying or selling stocks. This is not necessarily a bad thing as trading an index is no more a game of luck than trading FOREX or any other product. Regardless of whether you are trading real-time index ETFs or CFDs, index futures or index options, indices are always settled for cash. CFDs, ETFs, options, and futures will all be discussed in more detail in future What Is…? episodes.
Trading indices in real-time involves “buying” or “selling” into and index at it’s current value and “selling” or “buying” back out of that index when it’s value changes. Most major indices do not move many percentage points on a day to day basis so the majority of index traders will need to use leverage to make any real money. If the S&P is trading at $4,400USD most retail traders won’t be able to buy a single unit (known as a “standard lot”). Instead you could buy 0.1 or 0.01 of a lot at $440 or $44 respectively. Although for every point (or dollar) the index moves you would only make $0.10 or $0.01 respectively. Using leverage of 10:1 you could “buy” into a standard lot for $440 while still making $1 for every point. Leverage, however, always comes with risk. If the S&P were to drop 500 points to $3,900USD you would lose $500 despite only having invested $440. This would mean you would lose your entire investment and still owe your broker another $60. The higher the leverage the greater the risk.
SO WHY TRADE AN INDEX?
The first reason to trade indices is that they are safe relative to their stock or commodity counterparts. The bundling together of lots of companies means that if one falls the index will only partially fall. It is also easier to predict how an industry or market will move rather than stocks which are vulnerable to news events. Trades are able to be made with more reliability because Indices are traded at high volumes. This is called liquidity and we will learn more about it in episode 11. Finally, trading times are attractive for indices with some trading 24hrs Sunday to Friday similar to FOREX. Others trade through most of the day only closing for 4-6hrs overnight.
Series 1 – What is…?
Episode 2 – Indices
Next – Commodities
