In trading terminology, indices is a just plural form of the word index. So when asking, what are indices in trading, what we really mean is “what are indexes in trading?”
For new and experienced traders alike, the first index that is bound to come to mind is a type of stock market index (e.g. S&P 500 or FTSE 100).
Trading stock market indexes, or indices, has long been a popular option for traders because it is considered one of the best markets to trade on and is often spoken about on popular financial media (e.g. Bloomberg). Index markets often have clearer charts than other markets, and also possess high volatility meaning that their trend is often much easier to identify.
So for traders looking to get started trading the index market, here’s everything you need to know about trading indices.
Related Reading: Trading indices is just one type of trading. Read more about another type of trading, Commodity Trading, here.
What is an index?
In the financial industry, the market index, or any index, is simply an index that measures a given market. There are indices in the stock market, bond market, currencies, commodities and even cryptocurrencies.
Its analysis and measurements can help investors and traders to compare current price levels against previous prices to calculate market performance, and it can also track the general performance of a subset market. For example, stock market indexes can evaluate the performance of a particular market’s economy, region or sector.
An example of this in practice could be selecting a handful of different companies in different sectors, and calculating their share price average.
The figure, or the value, that the equation will show is the index of that particular group of stocks.
This is why trading indices can be one way of getting exposure to an entire sector or economy at once, without needing to open varied positions across lots of different shares.
What are the 3 major stock market indices?
There are a multitude of different indices and not all of the groups relate to countries. Some measure industry sectors, like pharmaceuticals or technology.
The three most popular indices are the three biggest U.S. stock indexes:
- The S&P 500: The biggest index in the world, it represents 500 of the biggest companies from across the United States
- The Dow Jones Industrial Average: Commonly shortened to Dow Jones, it comprises the 30 largest industrial companies across the United States
- NASDAQ 100: The NASDAQ 100 measures the 100 major technology companies across the United States. It’s not to be confused with the NASDAQ Composite which measures all the stocks listed on the NASDAQ stock exchange.
However other popular indexes include:
- The FTSE 100: The British equivalent of the NASDAQ 100, the FTSE 100 measures the 100 biggest technology companies in the United Kingdom
- The DAX 30: The German equivalent of the Dow Jones index, it measures the performance of the 30 leading German companies
- The NIKKEI 225: The NIKKEI 225 is the Japanese index, and it measures the performance of the 225 biggest companies across the country.
Factors that influence price movement in indices
One thing to be aware of with trading indices is their volatility. Though this can often be a positive factor if the right trend occurs, traders must be aware that stock market indices are open to volatile movements because they are influenced so heavily by four external factors:
- Financial reports and economic forecasts
- International and domestic political events
- Political unrest, terrorism and wars
- Natural disasters and health hazards
To keep up to date with influential factors on indices, traders can leverage Twitter to help with their trading strategies. Find out how.
Why are indices so volatile?
Significant movement occurs in indices because they differ from traditional trading markets, like Forex. Typically market prices are based on the amount of buyers and sellers, but indices aren’t a market. They simply represent the value of the average share price (or other calculation) of a group of companies.
As many indexes contain a number of companies — such as the S&P 500 and the FTSE — the index price will move based on the stock price movement of the companies in each index.
An example could be to use the NASDAQ index. Huge companies like Apple, Microsoft and Netflix are all represented by the NASDAQ index. If their stock price was to fall, the value of the NASDAQ index would also fall, regardless of how many people are buying and selling stocks of the companies.
How are stock indices calculated?
Learning how to calculate stock indexes is particularly useful for not only trading the stock index, but also trading the underlying stock of the companies themselves.
For instance, using our earlier NASDAQ example a trader considering a long trade on the NASDAQ index could analyse the individual stocks of Apple, Microsoft and others that make up the NASDAQ index to evaluate whether they would work in conjunction with the long trade.
If the trader believes that Apple and Microsoft stocks seem to be rising, perhaps on the influence of new products or technologies, then that would confirm the long trade. But on the other hand if Apple and Microsoft had received negative press recently, the trader may believe the value of the stocks will fall, putting them in disagreement with the long trade and potentially warning against executing it.
How to calculate a particular stock index is usually accessible on the website of the exchange that provides the stock indice. However commonly calculations follow two equations:
- A Direct Stock Index Calculation
Direct stock index calculations calculate the value of the underlying stocks equally. That means that one company’s individual stock is seen as valuable as all of the other companies.
An example of a direct stock index calculation may be 25 individual stocks whose prices are added together to calculate the overall price of the stock index.
- An Indirect Stock Index Calculation
Indirect stock index calculations calculate the value of the underlying stocks unequally. For example the value of one company’s stock could be seen as more important, and therefore more valuable when compared to another.
Indirect stock index calculations are much more complex than direct calculations, so an example could look like: 25 individual stocks whose prices are added together to make an overall price, which is then divided by 25, multiplied by the average trading turnover of each one of the company’s individual stocks, and then all these figures will be added together to create an overall trading turnover price of the index.
Talking of calculations, why not calculate your earnings potential in 2021 with us at Alphachain Academy?
How do you trade indices?
Indices are traded much the same way as Forex or any other stock trade. Trades are opened with the market in one direction, and then closed at the correct moment using usual trading strategies.
To trade indices, traders must:
- Choose the right index. When it comes to trading indices, it’s best for traders to come with some preexisting knowledge of either the index, or the companies within it. For example someone living in the United States may be in a better position to know more about the Dow Jones than the FTSE 100, although this shouldn’t dissuade traders from learning more about other countries, companies and their indexes.
- Choose how to trade. With indices there are two methods of trading, spread betting, where a trader bets on the difference between buy and sell prices, and CFD bets. CFD bets refer to Contracts for Difference where a trader and a broker will agree a contract in order to try and profit again from the price difference at the opening of the trade and its closing.
- Evaluate the market. Just like with any trading, indices should be analysed and trades evaluated before they are placed. Traders must choose a direction to trade in, and deduce whether they will go long (buy) or short (sell).
- Utilise their trading psychology. Indices are subject to significant volatility and this means that traders must weigh up their risk management strategies even more in order to keep safe.
- Monitor their trades. Once trades are placed on indices market volatility can cause the trend to rise and fall significantly, so traders must stay on top of market movement and choose the right moment in which to exit or close their trade.
Where to trade indices
If our guide has given you a taste for trading across the indexes, you can trade equity indices with us at Alphachain Academy. Our funded Global Trader Programme allows you to trade indices, forex, commodities and cryptocurrencies from the comfort of your own home, with access to trading psychologists, expert mentoring, and on successful completion of the training your own $20,000 funded trading account. Book your consultation with us here.