What are indices and how do they work?

Trading in different instruments and sectors can contribute towards a diverse profile, and this could mean investing in indices.

Indices are the collection of stocks and assets, which track the trajectory in a particular industry or area. They act as a tool to observe how parts of the market are performing, and as well as having the opportunity to invest in indices, traders can use them to understand market fluctuations. In this article, we explain further how to trade in indices, and the benefits they can bring to your portfolio.

Indices explained

The most commonly known indices are the collective stocks of the exchanges in major trading countries. These are America’s Standard and Poor’s 500 (S&P 500), the Frankfurt Stock Exchange 30 (DAX 30) in Germany and United Kingdom’s Financial Times Stock Exchange Group 100 (FTSE 100). So, taking the FTSE 100 as an example, this represents the 100 largest companies on the London Stock Exchange. Unlike stock trading, taking a position on the FTSE 100 index means that you are exposed to the market as whole, and essentially the rate of the UK economy.

If you are already participating in online forex trading or stock trading, then you’ll be conscious of volatility in the different markets. When it comes to indices, they place in the middle of the two in terms of volatility, with forex being the lowest. This means that index trading is a good option for day trading.

Indices are also highly liquid, and tend to have more trading hours than other instruments, as they involve markets from across the globe. There are also a range of factors that can affect their price movement, including the reports from the financial industry, such as central banks and payroll, and announcements from companies that could potentially affect their share value. You will also need to be aware of the prices in the commodities market, as there is some crossover with the shares in commodities companies in the FTSE 100, for example. If there is a fluctuation in the price of a commodity, this could then affect its corresponding stock value.

How are they calculated

The way in which the value of indices are calculated relies on the extensive accounting and reporting of the companies listed on the exchanges, of which are made public. In turn, companies such as the FTSE review these published reports, to examine and evaluate the strength of the publicly traded companies.

The method used does provide a greater weighting to the larger companies, to truly reflect the value they have within the market. This also means their performance will affect the price of the index as a whole, more so than the smaller companies. These evaluations are also made public, and so can be used as a tool for investors to influence their trading strategies and provide an insight into the health of the relevant companies’ stocks.

How to trade indices

The most common way to trade in indices is through future contracts (futures) or contracts for difference (CFD). With futures, there is the commitment to buy the specific asset at a certain price on a predetermined date, taking a ‘buy’ or ‘sell’ position according to how you think the market will perform.

To speculate on the value of these futures, investors have the opportunity to trade in the form of CFDs. This allows you to open a position based on the predicted direction that market will move, without owning the underlying asset. You will also be able to gain exposure to the index market using leverage, which can increase your potential gains as well as losses.

The benefits of index trading

On a daily basis, the value of indices can rise and fall, as the companies’ individual stock values can affect the market’s movement. Investors can use this to their advantage if they predict that a company will increase the index of a particular sector, for example an announcement by Apple or Netflix can have a positive impact on the technology industry.

Including index trading as part of your investment strategy can also be an effective way to offset trader risk, as the exposure is much greater than trading in a single stock. They are also less affected by inconsistencies and fluctuations of low performing companies, whilst maintaining their value.