What is an Index?
An index is basically a method that helps to assess the performance of a group of assets in a uniform manner. Index exchange generally weigh in the performance of a basket of securities that are expected to mimic a particular area of the market.
While these could be created as a broad-based index that covers the entire market, they may even be more specialized like the indexes which trace an industry or segment which looks only at small-cap stocks.
What Is an Index Fund?
An index fund is basically a mutual fund or ETF which attempts to copy the performance of an index, typically by creating its portfolio to copy that of the index itself. Index investing is known as a passive strategy because it does not include choosing any stock picking or active management. Studies indicate that over time, indexing strategies give better returns than stock picking strategies. Since they’re passive index funds, the fees and tax exposure are also low.
Different Ways to Construct an Index
Indexes could be created in many ways. Many times, we take into account how different components of the index are weighed. The three leading ways are:
- A market-cap or capitalization-weighted index backs the components with the largest market capitalization (market value), like the S&P 500
- A price-weighted index lays more emphasis on the components that have the highest prices
- An equal-weighted index weighs every component equally and is sometimes known as an unweighted index.
What Moves Stock Indexes?
Typically, there are three key factors that affect stock indexes: fundamental factors, technical factors, and market sentiments.
A company’s profitability is determined by fundamental factors.
The technical factors are associated with the company’s history such as charts, past traders and investors, etc.
Market sentiments are a reflection of the consumer influence, market image, and expectations of companies. Here are some other factors that can affect the index market:
- Global, economic, and company news
- Earnings base
- Political events
- Index reshuffle
What is Index Trading (for beginners)?
Index Trading can be understood as the buying or selling of a particular stock market index.
Investors would predict the increase and decrease in the rates of the index. On the basis of this, they would decide whether they wish to sell or buy shares. The index is a collective average of the stock performance, therefore you would not be required to purchase or sell any actual stocks.
Why trade indices?
In the last two decades, index trading and investing have become more popular than ever. This is because when you trade indices, you gain exposure to an entire economy or sector through just a single position, rather than opening a number of traders across many companies. Here are some more advantages of trading indices:
- Diversification. Instead of depending on a single stock, an index exposes you to a broad section of the market in one go.
- Lower volatility. Indices are typically less volatile than other asset classes, as their price movements are in check because of the large number of companies they track
- Accessibility. Instead of carrying out fundamental analysis on a niche stock to check if it’s undervalued, indices provide a larger picture of the overall economy
Even though indices are becoming more and more popular by the day, here are a few reasons why you should consider trading the stock market using CFDs.
- Go long or short: There are two options with CFD trading if you want to open a position: going long or short. Going long indicates that you are buying more because you think the market would rise. Going short implies that you are selling since you think the market would fall. Thus, you will be able to earn from the falling prices as well as rising prices.
- CFDs are leveraged: Which is great as you only need a smaller initial deposit which is called margin. You would be able to open a position where the exposure would be at par with what you would have experienced by investing in the stock market directly. Do remember that it magnifies any profits as well as losses.
- Hedging your existing portfolio: As an investor who owns a number of physical shares, you may short an index to keep your portfolio safe from potential risks. If the value of the stock market starts falling, your short position with the index CFD would rise, offsetting the losses from the stocks. But, it’s important to note that in case a stock market rises in value, your short index position may rule out the proportion of profits you have earned with your physical shares.
How are stock market indices calculated?
The majority of the stock market indices are calculated on the basis of the market capitalization of the companies that are part of the indices. This method gives more weightage to larger cap companies, implying that their performance would be impacted by an index’s value more than lower cap companies.
Note that there are some popular indices that are price-weighted. This method allows more weighting to companies whose share prices are high. It implies that any change in their values would impact the current price of an index.
Easy Three-Step Process Towards Index Trading
Pick your Index
There are plenty of indexes that you can track with the help of index funds. Depending on the sector you choose to trade in, you can select an index that includes the firms from your chosen industry.
Choose a Fund
Once you select an index, you then need to look for an index fund that can help you track it. There are a number of funds that track the same index, particularly the noted indices such as Dow Jones and S&P 500.
Open a Trading Account
Sign up with a broker and select from the account types that suit your trading needs.
Once your trading account is verified, you check out the available CFD assets where you may find some of the most popular indices. If you feel confident enough about going right into the markets, you could start by opening your first trade.