Find out the purpose of major and minor stock indices and how they are compiled. Learn how to gain exposure to these volatile markets through some of the most popular trading products in the world.
What is a stock index?
An index is a calculated average of selected share prices, representing a particular market or sector. You can think of an index as a ‘basket’ of shares that provides a broad sample of an industry, sector or economy. The collective performance of these shares gives a good indication of trends in the overall market they represent. As well as enabling investors to track changes in the value of a general stock market, indices also provide a useful benchmark to measure the success of investment vehicles such as mutual funds and share portfolios.
Best Brokers for Indices Trading
Indices to watch
There is an index for virtually every conceivable sector of the economy and stock market. Some of these are known as ‘major stock indices’, such as the Dow Jones Industrial Average (DJIA), the FTSE 100, the S&P 500 or the Nikkei 225. The main indices are provided by leading financial companies. For example, the FTSE 100 is owned by the London Stock Exchange and the Financial Times, while the S&P 500 is operated by financial heavyweight Standard & Poor’s.
Major indices provide the best way to gauge the performance of an industry, sector or whole country’s stock market.
Types of indices
Global or world indices
These include some of the world’s largest companies. For example, the MSCI World index measures 1500 stocks drawn from every developed market in the world (as defined by the provider, MSCI). This index is often used as a benchmark for global stock funds.
These show the performance of the stock market of a particular country, reflecting investor sentiment on the shares listed in that market. For example, the FTSE 100 represents the UK’s 100 (or around 100) largest companies as listed on the London Stock Exchange (LSE).
These are more specialised indices, designed to track the performance of specific sectors or industries. The Morgan Stanley Biotech Index, for example, tracks 36 US firms in the biotechnology industry.
As well as stock indices, there are indices for other financial markets which affect the economy. Significant examples include:
The US Dollar Index measures the value of the US dollar against selected foreign currencies.
The Continuous Commodity Index includes 17 commodity futures that are continually rebalanced.
The CBOE (VIX) Index measures expectations of near-term volatility. The measurements are derived from S&P 500 option prices.
How can I trade a stock index?
Stock indices cannot be traded directly, as they are not products in their own right. They exist only to provide information, so you can’t buy or sell a portion of an index as such. Instead, investors trade indices through derivatives such as CFDs, futures or options. In fact, stock indices are the most popular form of CFD trading.
How are indices priced?
Indices can be classified by the method used to determine their price. We explain the different methods below:
The price of each component stock is the only factor that determines the value of the index. The total value of the index is calculated by adding together the share price of each stock in the index, then dividing the figure by the total number of stocks. Higher-priced stocks therefore carry more weight, exerting more influence on the performance of the index.
The Dow Jones Industrial Average is an example of a price-weighted index.
The price of each component stock is weighted depending on its market capitalisation, so larger companies hold a larger percentage weighting. The total value of the index is calculated by adding up the market caps of each stock and dividing them by the total number of stocks. This means that sectors containing very large companies, such as the mining and banking sectors, influence their national stock indices greatly.
The FTSE 100 Index is an example of a capitalisation-weighted index.
A number of equities, indices or other variables are grouped together and standardised, to provide a statistical measure of a market or sector’s overall performance over time. They provide a useful benchmark against which to measure an investor’s portfolio. Composite indices can be either price-weighted or capitalisation-weighted: the term ‘composite’ simply defines how the contents are sourced.
The NASDAQ Composite is an example of a composite index.
How do dividends affect index prices?
Dividend payments from the constituent shares of an index will generally cause the price of that index to fall. This is because the value of an individual share tends to drop on its ex-dividend date by the amount of the declared dividend. If you have a futures position on an index, any expected dividend and interest payments will be factored into the price of the contract, so you won’t be affected by a drop in the index price.
If you have a long CFD position on an index that lists a company offering a dividend, you will also receive the dividend just as the company’s shareholders would. So, provided that you hold your long position at close of business on the day before the ex-dividend date, you shouldn’t find yourself adversely affected. The dividend payment you receive should counter-balance any loss caused by the drop in the price of the index. If you have a short position open at that point, you will pay the dividend instead.
Trading index futures
Index futures are the primary way of trading stock indices. All of the major stock indices have corresponding futures contracts that are traded on a futures exchange. The E-mini Dow is the main futures contract on the Dow Jones, for example. Index futures are essentially the same, and trade in the same way, as all other futures contracts.
TAKING A LONG POSITION
This means that you are buying the index at a fixed price now, for expiry on a set date in the future. You would do this if you expected the price of the index to rise between now and the expiry date, so you could profit by selling for a higher price than you paid.
TAKING A SHORT POSITION
This would mean that you are selling the index at a fixed price now, for expiry on a set date in the future. You would do this if you thought the price of the index would fall between now and the expiry date, so you could then profit by buying at a lower price.
Like other futures markets, index futures trade on leverage: you put down a margin of the total value of your contract, and this gives you magnified exposure to the market.
EXAMPLE: THE E-MINI S&P 500. The E-mini S&P 500 is one fifth of the size of the standard S&P 500 contract, and closely tracks the performance of the larger index. If you think the S&P 500 is going to increase in value over the next three months, you might choose to buy index futures on the E-mini.
The contracts are priced at $50 x the E-mini (futures) price. So if the E-mini futures price is at 1000.00, your $50 contract has a full exposure worth $50,000 ($50 x 1000.00). Like all futures products, you only need to put down a fraction of the full value of the contract in order to open a position; in the case of index futures, this amount is known as a ‘performance bond’. If the market moves against you, you might need to add additional funds to maintain the necessary margin. For every point the E-mini moves in your favour, you gain $50. For every point the E-mini moves against you, you lose $50.
Ticks are the minimum price movement of a futures contract. For the S&P 500 E-mini, the tick is 0.25 index points, which equates to $12.50 of a $50 contract; so if the E-mini price moves from 1000.00 to 1000.25, a buy position would gain $12.50 and a sell position would lose $12.50.
Why trade stock index futures?
As a form of derivative, futures can fit into your overall trading strategy. In volatility trading, for instance, the aim is to take small but regular profits from a volatile market.
Hedging against losses
If you have a portfolio of shares, you can limit your exposure to unwanted risk by opening an opposite position as an index future. So if you had a number of long shares positions, you could take a short position on the relevant index future. This would help you to offset any losses if your shares moved against you.
Being leveraged products, stock index futures give you exposure to a stock market or sector as a whole for a much smaller amount of up-front capital, and without having to purchase the individual constituent shares directly.
Futures contracts are standardised by the exchange, which mean you must deal in a certain size. This size might not exactly match your needs, especially if you are hedging an existing portfolio.
As you are dealing with such a high-value and volatile asset, you’re likely to need to put down a fairly substantial figure as your margin payment. You’ll need to maintain this margin throughout the time your position is open.
Ways to Trade Indices
CFD Trading on Indices
By trading index Contracts for Difference (CFDs) with IG, you can gain exposure to whole markets and sectors at a fraction of the cost and without the complexity of buying into the representative shares. Trading stock indices is our most popular form of trading CFDs. You buy contracts which stipulate that you’ll exchange the difference in value of a particular index between the time you open your position and the time you close it. This means that you can trade no matter which direction you think the index is going to move.
To find out more, please visit our CFD trading section.
CFDs are a leveraged product and can result in losses that exceed your initial deposit.
Spread betting on Indices (UK only)
In the UK, financial spread betting offers a tax-free* way to speculate on the price movement of a whole index, as well as other products such as forex, shares and commodities. As you cannot buy a portion of a stock index directly, spread betting offers an effective way to gain should the overall index move as you expect – and enables you to deal regardless of whether you think the index will move up or down. Some providers also offer sector bets, allowing you to back your opinion of a particular set of shares such as the banking or mining sectors.
Spread betting is a leveraged product and can result in losses that exceed your initial deposit.
*Tax laws are subject to change and depend on individual circumstances. Tax law may differ in a jurisdiction other than the UK.
Futures contracts enable two parties to exchange the difference in value of a stock index – or other asset – at a specified future date for a price agreed today.
All of the major stock indices have corresponding futures contracts that are traded on a special futures exchange. Investors often use index futures to protect their portfolios from the risk of the broader market falling. Alternatively you can use index futures to increase your exposure to movements in a particular index, adding leverage to your portfolio.