When you see a wide-eyed news anchor announce that “the stock market is at an all-time high!” ”, it really refers to the stock market index.
A stock index consists of a set of stocks in a market or sector. Traders and economists use it to compare returns on different assets, monitor the health of the global economy, or as an investment vehicle. Global, regional and national stock indices are among the most common types of indices.
Stock indices represent the value of a group of underlying companies listed on the stock exchange. A stock index replicates the performance of several stocks to measure the overall performance of a given market.
Why Trade Indices?
Stock trade indices are actively traded and popular among investors. They are a major asset that beginners can get their hands on, and they are also traded by seasoned professionals on a daily basis. Indices are suitable for both day traders and long-term traders. Here are some of the benefits of trading major indices:
- They are extremely liquid, allowing traders to benefit from tight spreads and clear charts;
- They offer volatility. Indices reflect the state of the economy to which they belong. Changes in the economy can cause the indices to become more volatile and therefore create great trading opportunities;
- Traders can speculate on the ups and downs of the index. This creates more opportunities as traders can take advantage of the trend, be it bullish or bearish;
- There are various industry indices which offer traders exposure according to their preferences. For example, if a trader wants to profit from the technology sector, he can trade the US Tech 100 index.
How is the Value of Stock Market Indices Calculated?
It is important for the stock market to be transparent about the stocks that make up the index and how the index value is calculated. It is easier for ETFs to copy transparent indexes because ETF managers allocate appropriate ratios to the various stocks that make them up. There are many methods of calculating the value of a stock index. Here are the most common:
Market capitalization weighting method:
Stocks included in the index are weighted according to the company’s market capitalization. The largest company in the index (in terms of its market capitalization) is the one that, by definition, has the most influence on the value of the index. The S&P 500, for example, is a market capitalization-weighted index;
Share price weighting method:
Shares included in the index are weighted according to their price. Because of this, companies with a lower market capitalization but a higher share price have a greater impact on the value of the index as a whole. The DJIA , for example, is an index weighted according to stock price;
Equal Weight Method:
All stocks in the index have the same weight in the index. Therefore, the performance of the index is equal to the average performance of each share. For example, the FANG+ index is an equal weighted index;
Fundamental Weighting Method:
The index is calculated using fundamental elements such as price/earnings per share (PER or Price Earnings Ratio), profit, book value, etc.
*The value of most indices is calculated using the market capitalization weighting method.
What Factors Affect the Price of Indices?
The value of the index fluctuates according to the evolution of its components, be it market capitalization, fundamental indicators or simply the share price. The method of calculating the index value can also lead to different results. Several elements affect the index values, namely:
1. Components of the index: The companies represented in the index influence the value of the index. Those with a large weight should always be monitored as they have the greatest impact on the price movement of the index;
2. Economic data: If, for example, an index is primarily composed of US stocks, such as the S&P 500, then data relating to the US economy is likely to affect the value of that index. Investors pay particular attention to indicators such as inflation, the unemployment rate, the level of inventories and Treasury yields. You will find all these economic data in our economic calendar;
3. Politics: Trade wars and regulation can negatively affect indices. In general, free trade, discussions around deregulation and tax cuts are helping the indices.
Top Tips for Index Trading
Trading indices is similar to trading other financial assets. Traders try to time the value of the index and then go long or short. The reasons for entering the position are very important, it is important to be aware of the developments in the stock market.
- To get an edge in the stock market, check out our stock market overview;
- Before opening a position, determine the risk/profit ratio;
- Follow economic data releases. Economic data can affect spreads and volatility;
- Traders should always improve their knowledge and skills.
How to Trade Stock Indices According to Your Risk Profile?
Trading the financial markets is certainly a risky business, but there are several methods of trading stock indices. Thus, each trader can adapt his technique according to his risk profile, namely the level of risk he is willing to accept in order to try to make money in the stock market.
If you are willing to take on more risk to ultimately make more money, you can go for very short-term index trading. Depending on your skills, and especially after learning on a demo trading account, you may have a better idea of which method to use between scalping and day trading, or a combination of the two methods.
It should be noted, however, that while leverage increases potential returns, it also increases risk with the risk of total loss of invested capital. Therefore, trading stock market indices in a very short-term perspective requires a good understanding of trading activity and its risks.
If you are willing to accept moderate risk when investing in stock market indices, you can switch to leveraged swing trading. However, it is still a risky business and a solid understanding of the risks is still necessary.
If you want to take minimal risk, you can choose long-term investments without leverage. Note, however, that this often requires more capital for the returns to be more interesting.
There is no such thing as zero risk in the stock market, but a good trading education and an approach that matches your investing style can greatly increase your chances of success in financial markets and stock index trading.
How to Trade on Stock Indices?
Stock indices are a distinct asset class that lends itself to several types of index trading strategies. You can do index scalping, day trading, index swings and even look at long term positions.
Indeed, stock market indices offer all the right conditions for trading. As such, trading the major international stock indices typically offers excellent liquidity, volatility and trending conditions.