What is indices trading?
Index trading is a popular way for investors to gain exposure to financial markets without having to research and invest in company stocks directly. Trading stock market indices is a way to reduce risk in stock trading. Rather than buying and selling individual company shares, you trade an index, or compilation of shares.
In this indices trading guide:
- What is indices trading?
- What is an index?
- Benefits of indices trading
- What are the top 5 stock market indices to invest in?
- What is the most popular stock market index?
- What factors influence stock market index prices?
- How are major indices calculated?
- How are indices compiled?
- The history of index trading
- How to trade indices
- How to trade indices CFDs?
- Trade indices CFDs with Capital.com
What is an index?
An index is calculated from the price of its constituent stocks, typically as a weighted average. Any index lists the criteria a company must meet to qualify for inclusion.
By tracking the performance of a large group of shares, an index aims to reflect the state of a broad industry sector, or a country’s stock market as a whole.
Fund providers create active and passive index-linked funds, and derivatives for investors to buy and sell. Indices reflect the performance of the overall stock market. Movement in an index’s value indicates the health of the economy or industry sector it tracks.
Generally, there are seven common types of indices: global, regional, national, exchange, industry, currency and sentiment-based.
The world’s major financial markets each have at least one financial index. For example, the S&P 500 (US500) is an index of the 500 largest companies in the US.
The Euronext 100 (N100) tracks the largest stocks on Europe’s Euronext exchange, comprising companies listed in The Netherlands, France, Belgium, Portugal and Luxembourg. Other major indices include the UK’s FTSE 100 (UK100), Germany’s DAX 30 (DE30), Hong Kong’s Hang Seng (HK50) and Japan’s Nikkei 225 (J225).
Industry-specific indices are popular among traders. For example, the NASDAQ–100 (US100) in the US lists the leading 100 high-tech company stocks. It’s used as a barometer of the US technology sector’s performance.
Stock market indices are often referred to in news reports on financial markets and economies. They’re considered indicators of confidence in business and the stock market, performance by top companies in the given market, and economic health.
Stock markets are affected by political events and monetary policy, such as interest rate changes, currency fluctuations and international trade.
Benefits of indices trading
Many individual investors opt to trade indices in their investing accounts, particularly if they’re saving for retirement.
Index trading gives investors exposure to a range of companies. While some company share prices fall over time, others rally. Diversification evens out extremes in volatility.
Index values fluctuate each trading session, but they do not lose or gain large amounts unless there’s a major change, like a market crash, geopolitical event or natural disaster.
Indices pose a lower risk than investing in individual stocks. If you invest in a company stock and the company goes bankrupt, you can lose your investment. But if one company in an index folds, it can be replaced by the next largest company outside the index. Depending on the size of the failed company and the performance of the other constituents, the value of the index may dip temporarily, or it may have no noticeable impact at all.
On the other hand, index investing limits the returns you receive from a high growth company. Individual growth stocks can outperform an index by large multiples, although they carry higher risk.
What are the top 5 stock market indices to invest in?
There are 3.05 million stock market indices around the world, according to the Index Industry Association. They range from large company indices to industry sub-sectors, such as consumer staples, and themes, like environmental, social and governance (ESG).
The top five indices by volume are the NASDAQ–100, S&P 500, Hang Seng, FTSE 100 and DIJA.
The NASDAQ–100 is an index of the 102 largest US and international non-financial stocks on the NASDAQ Stock Exchange. The holdings are heavily allocated towards industries such as technology, consumer services and health care.
The NASDAQ–100 is a modified capitalisation-weighted index – it’s weighted towards stocks with the highest value. A company’s market capitalisation (also known as market cap) is calculated by multiplying the number of shares it has outstanding by its share price. The index has certain conditions that limit the influence of the largest companies.
Technology companies account for a 56% share of the index’s weight. The 10 largest account for 57.5% of the index.
The NASDAQ selects its constituent stocks once a year in December, based on market data at the end of October and the total of outstanding shares at the end of November. The index is rebalanced every March, June, September and December.
S&P 500 (US500)
The S&P 500 is compiled by S&P Dow Jones Indices and governed by the US Index Committee. It’s one of the most popular indices. The large number of diverse companies it tracks is viewed as one of the best indicators of the performance of US markets and the overall economy. The index covers around 80% of the market capitalisation of the US stock exchanges.
The S&P 500 is weighted by the float market capitalisation of constituent stocks, meaning it includes shares freely traded on the market and not shares held by company board directors, executives and other insiders.
Companies must meet several criteria to be eligible for inclusion, such as earnings, liquidity and share float. Even then, acceptance is not automatic. Companies must continue to meet the requirements or face removal.
Decisions are made at the discretion of the US Index Committee, which meets regularly to make decisions about admitting companies to the index and implementing changes to the methodology. The index is rebalanced every March, June, September and December.
S&P Global estimated that there was over $11tr in funds benchmarked to the index at the end of 2019, including $4.6tr in passive tracker funds.
Hang Seng (HK50)
The Hang Seng is an index of the largest companies in Greater China listed on the Hong Kong Stock Exchange. Managed by Hang Seng Indexes, a subsidiary of Hang Seng Bank in Hong Kong, the HK50 is an adjusted market cap-weighted index based on companies’ free float shares. It applies an 8% cap to prevent a single stock from dominating the index.
To reflect price changes in the market’s major industries, stocks in the index are grouped into four sectors: finance, utilities, property, and commerce and industry.
The index expanded from 55 to 58 companies on 7 June 2021. Its target is to include 80 companies by mid-2022 and then be fixed at 100 companies, with 20-25 constituents classified as Hong Kong companies.
Stocks are evaluated for eligibility by the HSI Advisory Committee based on how representative they are of the market, turnover, financial performance and market cap. Constituents failing to meet these requirements can be considered for removal.
The smallest and least liquid constituents may be considered for removal even if they meet the criteria, depending on whether there are appropriate replacements. The index is reviewed and rebalanced every March, June, September and December.
FTSE 100 (UK100)
The Financial Times Stock Exchange 100 Index, known as the FTSE 100, is an index of the 100 largest companies listed on the London Stock Exchange by free float market cap, with companies screened for size and liquidity. It’s compiled by FTSE Russell, a subsidiary of London Stock Exchange Group (LSEG).
As the UK is one of the world’s largest economies and a major financial centre, the FTSE 100 is an important indicator of the performance of UK businesses. The FTSE index represents around 81% of the value of the UK market on the London Stock Exchange.
Stocks are screened for price, voting rights, free float, foreign ownership, size and liquidity. The index is rebalanced quarterly.
Dow Jones Industrial Average, or DJIA (US30)
The DJIA was founded in 1896, making it one of the world’s oldest indices. Typically referred to as “the Dow”, the index is compiled by S&P Dow Jones Indices.
Unlike the S&P 500, the index is weighted based on the price of one share in each of its constituent companies. The index lists 30 blue-chip companies in the US and covers all industries except transportation and utilities.
The DJIA has no formal eligibility criteria. A stock is typically acceptable if the company is headquartered in the US, has a good reputation, sustains growth over a period of time and a large number of investors are interested in trading the stock. The index is governed by the Averages Committee, which makes changes as needed rather than on a regular schedule.
There was $32bn benchmarked to the Dow at the end of 2019, including $28bn in passive securities, according to S&P Dow Jones Indices. The trading volumes of investment products linked to the Dow are high relative to the number of assets that track the index, reflecting the index’s popularity.
What is the most popular stock market index?
Between 2009 and 2019, the NASDAQ-100 gained 372%, based on price, with a total return of 430%, including dividends. However, as always, it’s crucial to remember that past performance is no guarantee of future returns.
With such a concentrated focus on high-growth companies in the technology sector, the NASDAQ–100 is the most volatile major US market index. While that implies higher risks, it also presents opportunities for investors to profit from trading on volatility.
Comparing total annual returns, which reinvest dividends, the NASDAQ–100 Total Return Index has outperformed the broader S&P 500 Total Return Index in 11 of the past 13 years, according to a first-quarter review by Nasdaq Investment Intelligence.
In 2020, the NASDAQ–100 outperformed the S&P 500 by more than 30%. But it’s important to note that there are also periods of underperformance, such as the first quarter of 2021, when the NASDAQ-100 gained 1.76% compared with a 6.17% gain for the S&P 500.
The range of trading products available means that investors who want to gain exposure to the NASDAQ–100 but at the same reduce their risk can invest in the NASDAQ–100 Equal Weighted Index (NDXE). The NDXE gives each component stock an equal weighting of 1%, allocating only 10% to the top 10 holdings, rather than more than 50%. This makes the weighting more diversified and less concentrated on the index’s technology stocks.
What factors influence stock market index prices?
Stock market index prices fluctuate based on constituent companies’ share prices. For indices that are weighted averages, the performance of the largest components exerts more of an influence.
Interest rates set by central banks, such as the US Federal Reserve, Bank of England and European Central Bank, affect the broad performance of stock markets. Expansionary monetary policy, including lower interest rates and active asset purchases, tends to drive stock market rallies, whereas increased interest rates tend to weigh on stock markets.
Indices weighted towards companies that generate most of their revenues abroad can also be influenced by currency exchange rates. For example, the FTSE 100 includes companies that have benefited from weakness in the value of the pound sterling in recent years, as they received higher income when converting sales revenue in foreign currencies into pounds.
Elections and other political events can affect stock market performance. US presidential elections exert an influence over markets internationally, as investors consider the impact the policies of an incoming administration are likely to have on the world’s largest economy.
The UK’s exit from the European Union (EU) has had a strong influence over the FTSE 100 and European stock indices since the Brexit referendum of 2016, with sentiment over the prospect of the two sides reaching an agreement driving volatility. There is still uncertainty over the long-term relationship between the two sides as they continue to negotiate the details of a trade agreement and the UK’s exit settlement.
How are major indices calculated?
The first indices were calculated as simple averages. The share prices of all the constituents were totalled and divided by the number of companies. But some major indices today, like the NASDAQ–100 and Hang Seng, are weighted averages. The two major formulas used to calculate the value of a weighted index are value weighted and price weighted.
Market-weighted indices are calculated on the total market cap of their constituent companies. This means that the largest companies have the most impact on the index’s value.
The market cap of each company is calculated based on free float shares publicly available for trading. A company’s free float market cap is lower than its total market cap, as it excludes shares held by company insiders.
Price-weighted indices are calculated on the share price of their constituent stocks. This means that companies with the highest share prices have a stronger impact on the value of the index.
Price-weighted indices are less common than those based on market cap. The Dow Jones Industrial Average is the best-known example of a price-weighted index.
How are indices compiled?
Indices are managed by committees, which set the criteria that company stocks must meet to be eligible for inclusion.
These committees meet regularly to review the index rules and make decisions about whether to add or remove companies. Some committees hold reviews quarterly while others opt for annual reviews.
Some committees remove stocks that no longer meet the eligibility criteria, while others allow them to remain, or give them time to return to compliance.
The history of index trading
The first indices were published by financial journalists. The Dow Jones indices were calculated in the late 19th century by Charles Dow, who became the editor of The Wall Street Journal newspaper, which launched in 1889, and statistician Edward Jones.
The DJIA is the world’s second-oldest index, as it followed the creation of the Dow Jones Transportation Average, also known as Dow Jones Transports, in 1884. The transportation index calculated the average change in stock prices for the 11 largest transportation companies, of which nine were railroads. The indices were first published in the Customers’ Afternoon Letters, a two-page daily financial news publication.
The stock market boom that preceded the 1929 crash increased interest in stock market indices. The Standard Statistics Company, the predecessor to Standard & Poor’s (S&P), published its first stock index in 1923. And the New York Times and New York Herald Tribune began publishing indices during the 1920s.
The bull market recovery from the crash during the 1930s saw the launch of more indices, such as the Financial News Ordinary Index in 1935, launched by the forerunner of the Financial Times, which subsequently became known as the FT 30.
The first index fund for investors launched in the 1970s, and the first US ETF launched in 1993 – Standard & Poor’s Depositary Receipts (SPDR) S&P 500 ETF. Investor interest in trading baskets of stocks grew after the 1987 stock market crash and the technology boom, which began in the 1990s.
The explosion in the popularity of ETFs since the 2008 financial crisis has driven interest in stock market indices, as more investors have been drawn to passive investment strategies. Indices are predominantly used for benchmarking ETF portfolio returns, according to the Index Industry Association.
How to trade indices
Trading stock market indices is a way for individual investors to gain exposure to global or regional markets, without having to spend time analysing the financial statements of numerous individual companies. It also reduces the risk of exposing your portfolios to individual companies’ poor performance or bankruptcy.
Popular stock market indices offer investors high levels of liquidity, and tight bid and ask spreads for buying and selling, making it easy to enter and exit positions.
Investors can trade indices via investment funds that manage the process on their behalf:
Passive funds, also known as tracker funds, hold stocks in the same proportion as the index to match its performance.
Active funds are managed by fund managers, who aim to outperform the index.
Investment products, such as mutual funds, collect dividends paid on the company stocks in the index. They either distribute them to investors, known as a distribution fund, or reinvest them, known as an accumulation fund. Fund managers charge an annual fee as a percentage of the fund’s value.
Exchange-traded funds (ETFs) are an increasingly popular way for investors to trade index funds. ETF fund managers, such as Vanguard, charge relatively lower fees, so investors keep more of their returns. As they are traded on exchanges, the price of an ETF fluctuates throughout the trading session, unlike a mutual fund for which the price is settled once daily. ETFs can be bought and sold quickly and easily through stock trading platforms.
In addition to index funds, there are several derivative products based on indices that investors can trade to try and maximise returns. These include options or futures contracts that investors can use to hedge against fluctuations in the level of the indices, or speculate on whether they will rise or fall over a short period of time.
Another popular way to trade global indices is with contracts for difference (CFDs) on online trading platforms.
How to trade indices CFDs?
A contract for difference (CFD) is a type of contract between a broker and a trader, where one party agrees to pay the other the difference in the value of an asset or security. The trader aims to make a profit from the difference between the price of the asset when they open and close the trade.
Using CFDs to trade indices allows you to try to capitalise on market fluctuations in both directions:
Long – if you think the FTSE 100 will rise, you can take a long position.
Short – if you believe the FTSE 100 will fall, you can take a short position.
In contrast, if you buy an index fund directly, you only make a profit if the value rises.
You can trade directly with your CFD broker rather than using an exchange or mutual fund provider.
Trade indices CFDs with Capital.com
Capital.com’s trading platform offers several important advantages for trading stock market indices CFDs:
Advanced AI technology at its core: a Facebook-like news feed provides users with personalised and unique content depending on their preferences. If a trader makes decisions based on biases, the innovative News Feed offers a range of materials to put them back on the right track. The neural network analyses in-app behaviour and recommends videos and articles to help polish your investment strategy. This can help to refine your approach when trading the most popular stock market indices.
Trading on margin: providing trading on margin, Capital.com gives you access to the NASDAQ 100, DAX 30, FTSE 100, Dow Jones 30, S&P 500, CAC 40, Hang Seng, ASX 200, Euro Stoxx 50 and many more indices without you needing to have a large amount of funds in your account.
Trading the difference: by trading CFDs on indices, you don’t buy the underlying asset, meaning you are not tied to it. You only speculate on the rise or fall of its value. CFD trading is no different from traditional trading in terms of its associated strategies. A CFD investor can go short or long, set stop and limit orders, and apply trading scenarios that align with their objectives.
All-round trading analysis: the browser-based platform allows traders to shape their own market analysis and forecasts with sleek technical indicators. Capital.com provides live market updates and various chart formats, available on desktop, iOS and Android. Study live indices quotes within the platform, while browsing tailored news based on your trading behaviour.
Focus on safety: Capital.com puts a special emphasis on safety. Licensed by the FCA, CySEC and NBRB, it complies with all regulations and ensures that its clients’ data security comes first. The company allows traders to withdraw money 24/7 and keeps traders’ funds across segregated bank accounts.
Join Capital.com and always stay on top of the latest stock market news, analysis and forecasts to spot the best trading opportunities.