What are indices in trading and how to trade them?

S&P 500, CAC 40, NASDAQ or DAX - while studying the Forex market, you may have come across these mysterious abbreviations, behind which lie the names of the largest stock market indices. A stock market index is an indicator of the state of the stock market, which is calculated on the basis of a certain set of stocks and bonds. Several instruments are selected to create an index. For example, CAC 40 is an index that tracks the 40 largest French companies with the largest market cap on the Euronext Paris exchange, and the S&P 500 index includes about 500 of the largest US companies: Apple, Microsoft, Tesla and others.

However, it is important to note that indices are not just made up of stocks. There are bond indices, commodity indices, and even indexes of indices! Index calculation tools can be selected by industry, market cap or company size and so on. The value of a stock market index is calculated from the value of the instruments included in it. The most popular world indices usually include a list of the country's largest companies from various sectors of the economy.

Changes in the share prices of individual companies affect the overall value of the index. If the prices of most stocks rise, the value of the index increases, and vice versa. Thus, the stock market index reflects the overall sentiment and direction of the market. To find out whether all Parisian stocks rose or fell during the session, we look at the CAC 40 index, and if we are interested in the EU economy, we look at the Nikkei 225 index.

Classification of indices

There are thousands of instruments on the stock market, so it can be difficult to find an interesting stock to buy. Stock market indices partially help investors by categorizing instruments: indices of technology stocks, indices of gold stocks, China's largest capitalizations, etc. Thus, we can distinguish 2 main types of indices:

• Sectoral: These are calculated for a specific sector of the economy, for example, chemical or heavy industry.
• Composite (composite): They are calculated on the basis of shares of companies represented on a separate exchange. They serve as an indicator of the state of the economy and are used to forecast its development at all levels.

An index is a relative measure of an instrument's performance relative to a sector. If, for example, a stock outperforms its index, it is said to have outperformed the index or sector. If it underperforms the index, it is said to underperform the index. Sectors can also be compared across indices. It is easy to compare the technology sector to the pharmaceutical sector. Investors can learn which sectors are growing the fastest and which sectors are the best defenses against economic ups and downs.

Why are stock market indices important?

Stock market indexes act as a barometer, indicating the overall movement of the market. They help investors determine the overall trend in the market, showing all positive and negative movements of securities. In addition, indices are important in assessing the market sentiment. Market sentiment is an important concept that shows what most investors are doing: buying, selling, or staying on the sidelines. You can even determine investor sentiment for a particular sector.

Helping with passive investing

Another important function of indices is to enable passive investing. Passive investing involves investing in securities in a way that follows market trends as closely as possible. Investors who want to reduce research costs and brokerage commissions can invest in an index fund. The performance of the portfolio will closely match the performance of the index being tracked. This type of investment is made through index funds such as ETFs and is considered relatively stable, especially for the most stable indices.

How to trade indexes?

There are two main ways to trade indices - CFDs (Contract for Difference) and ETFs (Exchange Traded Funds):

CFDs on indices

Indices can be traded with online brokers using CFDs. They allow you to profit from the rise or fall of indices. The most popular index contracts are available: CAC 40, DAX, S&P 500, NASDAQ 100, etc. The principle of operation is simple: you buy a contract to buy or sell in the number of lots determined by your broker. This varies from broker to broker, so it is worth testing the appropriate platform before trading index CFDs.

Index ETFs

ETFs are also a great way to gain exposure to indices. These funds try to replicate stock market indices exactly. They are similar to mutual funds, but are listed on a stock exchange and traded throughout the day. This means they can be actively traded, but ETFs are best suited for long-term investing. They allow you to track market dynamics rather than trying to "beat" the market by picking individual stocks. ETFs allow for passive management. For example, the Lyxor CAC 40 ETF issued by Lyxor (a subsidiary of Société Générale) is an ETF that can be purchased to reflect the performance of the Paris index in your portfolio.

Benefits of stock market indices

• Reduced risk and steady growth: One of the main advantages of indices is that they are relatively low-risk equity investment options. By nature, they are diversified and therefore not very volatile. Investing in them through ETFs increases your chances of realizing long-term capital gains, and it does so passively. Active trading, on the other hand, is more complex.
• Lower costs: ETFs offer investors significant savings. ETF management fees range from 0.05% to 1%. However, actively trading CFDs on indices can be costly, especially if it is done using significant leverage.
• Diversification: Because you are investing in a basket of stocks, you reduce your risk. Indices allow you to diversify across the entire sector. By buying multiple indices, you can access multiple sectors at the same time, which would be tedious if you were buying stocks individually.

However, index trading has its drawbacks, the main one being the relatively low volatility. In other words, you cannot expect exceptional returns because indices do not grow significantly throughout the year. On the other hand, the low yield is compensated by high stability, so indices are well suited for long-term investments.In addition, when trading CFDs, you should not forget about leverage. Although indices are considered to be stable, leverage in this case makes index trading quite risky. It significantly increases the risk. Despite this, indices remain a popular investment method for many traders due to their stability and relative predictability.

FAQ

Q: How are index prices calculated?
A: Today, index prices are calculated using the market cap method, which measures the value of a company's stock relative to its total market cap in dollars, as well as a price-weighting formula. The calculation requires multiplying the number of shares of a company's stock outstanding by the current market cap of the stock. With this method, higher priced companies are given more weight, which means that fluctuations in the price of these stocks will have a greater impact on the current value of the index.

Q: What is the difference between index trading and stock trading?
A: Stock trading is trading shares of specific companies. Index trading is trading an entire set of stocks using a single instrument. An index tracks the price fluctuations of that set of stocks used as an indicator of the overall stock market picture as a whole (e.g. S&P 500), or it can be a specific segment of the stock market, such as technology (NASDAQ).

Q: Is index trading profitable?
A: Index trading is characterized by a relatively low volatility, i.e. you should not expect a large return in the short term. At the same time, indices are stable assets that perform well in the long term.