What Are The Main Stock Market Indices and How Can Traders Use Them Efficiently?
Would you like to trade in the stock market and avoid high volatility? There are many ways that will help you, one of which is trading stock market indices. It’s the best option to limit market fluctuations and hedge your portfolio.
Stock Market: Definition
Before we move to the concept of a stock index, let’s clarify what the stock market is. The stock market is a place represented by different markets and exchanges where equities of publicly-held companies are bought, sold, and issued. All the financial activities in the stock market are held on formal exchanges or over-the-counter marketplaces.
Even though the stock market is a common name for the world market, every country has its own markets with stock exchanges, stocks, and indices. If you want to trade equities, there are several options. You can invest in real company’s stocks, trade stock CFD, and trade stock indices.
What Is a Stock Index?
A company’s stock, equity, or so-called share is a security that is sold by the company’s owner to attract investments. The equity gives its investor the right to own the company in proportion to the number of shares he/she owns. Now that we know that a company can go public and sell its shares in the market.
When we talk about a stock index, we do not mean only one company, but many companies that make up the index. Thus, an index is a benchmark that includes equities of the companies usually placed on a particular stock exchange.
The companies included in an index can change if they don’t meet the index’s requirements.
However, an index can’t include all the companies listed on the exchange. Thus, every index has the requirements for the companies. Mostly, an index consists of those with the largest capitalization. Therefore, if a company suffers losses or what is worse, it goes bankrupt, it will be excluded from the index and replaced by another one.
Stock Market Index: Basics
All indices can be grouped by the sphere they represent. The types of indexes can reflect the health of the entire country. For example, DAX 30 relates to the German market; Israel 35 represents the Israeli market. An index can refer to a specific industry, for instance, the Nasdaq Composite Index. Or just refer to a group of the country’s stocks, e.g., the S&P 500.
A stock market index is used as a gauge of the whole market sentiment.
In general, an index represents the health of a country or industry it relates to. As an index consists of different stocks, if their price goes down, the index falls. If the price rises, the index increases. However, you understand that it’s impossible for all the stocks to rise or fall at the same time. Thus, as many shares represent an index, only significant price changes can make it move and only essential events in the market force it to move.
Indices are calculated in different ways, but most of them reflect the average meaning of the current value of the included stocks. Usually, companies with larger capitalization have a more significant impact on the index value.
There are two methods of index calculation. They are direct and indirect:
- The direct approach is more straightforward. To calculate the index value, you need to add the prices of all stocks included in the index. This will be the value of the index. In this method, all the stocks are weighted equally. Thus, there is no company that will have a more significant impact on the index value.
- The second method is an indirect calculation. To calculate the index in this way, you should add the values of all the index stocks, divide the sum by the number of stocks, and multiply the result by the average trade turnover of each equity. Then, add the results to get the index’s trading turnover weighted price. As you can see, with this method, the stocks are estimated unequally. Thus, some will affect the overall index value more strongly.
You can find a particular method of calculation on the exchange’s website. However, if the index is not as famous as the S&P 500 or Nasdaq composite, there is a chance you won’t find the calculation method.
Why Stock Index Matters
Stock indices aren't that widely used among traders as currencies or commodities. But they are crucial for those who evaluate global market sentiment. If you read news about the stock market, you will see that every financial news agency mentions stock indices at least several times per day to reflect the current market events.
Thus, we can say that the index is crucial as it determines the economic health of the country or particular industry it relates to.
Leading Stock Indices
Every country has its own index benchmarks. Still, there are indices known around the world. They determine the health of the global economy and are followed by investors and traders from every part of the world.
Dow Jones Industrial Average or DJIA
It’s an index of 30 North American stocks traded on Nasdaq and New York stock exchanges. Historically, it determines the health of the US economy. Only companies with strong growth and notable investing capacity make up the index. Companies can be replaced regarding the non-quantitative criteria.
The DJIA is the second oldest index that historically reflects the health of the US economy.
More expensive stocks have a higher impact on the index value. To calculate the index, you need to determine the sum of the stock prices and divide the sum by a divisor. The DJIA doesn’t cover transportation and utilities. Such companies are included in the Dow Jones Transportation Average (DJTA) and Dow Jones Utilities Average (DJUA).
S&P 500 or Standard & Poor’s 500 Index
It represents the 500 largest US publicly-traded companies. It’s a float-weighted index, so the company's market capitalization is gauged by the number of shares that are placed for public trading. Mostly, the index consists of technology companies and financial firms. The list is reviewed quarterly. Thus, some of the companies can be replaced if they don’t match the index requirements anymore.
The S&P 500 includes only those companies that are available for public trading.
If you check the list of the included companies, you may find more than 500 stocks. This may happen because some of the companies have several equity classes.
The calculation of the index is based on the weighted method. Thus, the companies with the largest capitalization have a greater impact on the index value. To calculate the index, you need to divide the company’s market capitalization by the total of all market capitalizations in the index.
There are other variations of the index, for example, S&P MidCap 400, which reflects companies with the middle capitalization, and the S&P SmallCap 600, which consists of companies with small capitalization.
Nasdaq Composite Index
The index represents stocks of more than 3,300 companies listed on the Nasdaq Stock Exchange. The index includes not only companies with US headquarters but a wider range. But to become a part of the index, a firm should be exclusively listed only on the Nasdaq exchange. There is one exception - if the company was registered on another US market before January 1, 2004, and continues to be dually listed.
The Nasdaq Composite Index is used by investors to evaluate the sentiment of the tech industry and risky equities.
It’s a weighted index that considers the market capitalization. The index is mostly composed of tech companies. However, other industries are also represented on the list. Unlike the S&P 500, the index includes large, small, and even speculative companies. Thus, investors use this index to evaluate both the health of the tech industry and the sentiment of risky equities.
To calculate the index, you need to multiply the total value of equities by the last price of each stock. The result is divided by a unique index divisor. The final value of the index is available daily at 4:16 p.m.
FTSE 100 Index
FTSE 100 Index, FTSE 100, Financial Times Stock Exchange 100 Index, or simply the “Footsie” represents 100 companies with the largest market capitalization of the London Stock Exchange. Although FTSE 100 includes foreign companies, it’s used as a gauge of the health of the UK economy. The strength of the British pound highly affects the index.
DAX 30 or Deutscher Aktienindex is a German index that is made up of the 30 largest German companies listed on the Frankfurt Stock Exchange. The calculation is based on the Xetra, an electronic system that submits the prices for the index calculation. The index is a benchmark not only for German but for the whole European market.
Trading Stock Index: Benefits and Drawbacks
If you decided to trade stock market indices, you should know about all of the pros and cons.
|No doubt. When trading stocks, you are at a crossroads: what company to choose. When trading an index, you don’t need to choose; the index is composed of the shares of the largest and most widely traded companies.||Difficult to follow. As an index consists of many stocks and the list always changes, it’s not easy to predict the market moves considering the companies included in the index.|
|Hedge. An index can be used as a hedging tool. Stocks are risky assets. Since it consists of many stocks, the price fluctuations are smoothed.||Lower liquidity. Indices are not widely traded. Thus, the liquidity of some can be inferior, especially if we are talking about the lesser-known ones.|
|Stability. The stock market is highly volatile. Nevertheless, the indices are a less risky instrument that can be used for trading and investing.||Limited opportunities. This disadvantage relates to the whole stock market. For forex trading, you have 24 hours 5 days a week to trade. At the same time, the trading hours of the stock market are limited by local business hours.|
|Market outlook. If you follow indices, you are always informed about market sentiment. Also, choosing indices, you fully understand the current situation of a specific country or industry. For example, if you select the Nasdaq Composite Index, you are aware of the situation in the tech industry. If you choose the DAX, you are familiar with the conditions of the German market.|
Trade Indices or Invest in Stocks
Before we compare index trading and stock investing, it’s crucial to understand that it’s impossible to buy an index. Thus, if you want to use an index as one of the securities of your portfolio, you can trade on the price fluctuations.
It’s impossible to buy an index.
If you decide to invest in stocks, you will meet plenty of difficulties. Firstly, you need to choose a company that is supposed to outperform in the future, so your investment will rise in value. Secondly, when you invest in real stocks, there is a high risk of high market volatility. Thirdly, to buy the company’s shares, you need significant funds as the price is not low. Also, if you consider stock investing as a long-term perspective, it’s not enough to buy one company’s shares.
At the same time, indices trading are much easier and offer several options to trade on the stock market index:
- You can buy an index fund. To do so, you will need to pay management fees. However, there is a vast range of fund companies to choose from.
- You can trade ETFs. They are traded on an exchange and represent a pool of stocks.
- You can trade CFDs.
Stock Index CFDs
CFD means contract-for-difference, and it’s the easiest way to trade stock indices. Thus, you don’t own real shares, but you have an option to trade on the price fluctuations. To trade stock index CFD, you need to find a reliable broker. After you deposit money, you can buy and sell stock indices available on the broker’s website. For example, Libertex offers 19 indices from different continents.
CFD is the easiest way to trade on the stock index.
If you know how to trade currencies, you won’t have difficulties trading CFD. Additionally, CFD trading supposes you have a leverage option. Thus, to start trading, you may need not more than $20. But be careful, leverage raises not only your potential profits but your losses. The significant advantage is that you can both buy and sell indexes on any timeframe and anytime you want.
How to Predict Index Direction
As for any other asset, you need to know how to predict the market direction:
- Check the list. It’s important to know what companies have the most significant weight on the index. So, you can check the news regarding those companies and predict the value of an entire index.
- Learn the components. As an index is made up of many stocks, you need to know the industry they relate to. It’s not necessary to know all of the companies on the list, just their industry. After, you will need to follow industry news and events to predict the stocks’ direction.
- Follow global news. All the leading indices are correlated with global market sentiment. For example, if there are trade wars, pandemics, risks of an economic recession, the largest indices will depreciate, reflecting the whole market sentiment.
- Currency-index correlation. Many indices experience a strong correlation with domestic currencies. For example, if the USD appreciates, it’s more likely the S&P 500 will increase too.
- Commodity-index correlation. If the country highly depends on either exports or imports of any commodity, the commodity’s price may affect the country’s indices.
Trade Stock Index: Complete Guide
As we said above, CFD trading is the best option when trading stock indices. Thus, let’s consider how to trade stock index CFD step by step:
- Find a trustworthy broker. A broker should provide CFD trading and offer several indices to choose from.
- Open an account. To start trading CFD, you need to open an account. There is a demo account and a real account. If you think you are not skilled enough to start trading indices on a real one, you can open a demo version. A Libertex demo account allows you to trade index CFD for free. It duplicates the real market and provides all the indicators you need.
- Choose the index. Previously, we mentioned the most famous indices. We recommend choosing them as they have more considerable liquidity, and it’s more likely you will find them on your broker’s website.
- Open a chart. An index chart doesn’t differ from currency, commodity, or stock charts. The chart reflects historical and current price movements. As we have mentioned, you can both buy and sell the index. Remember about a timeframe. If you are interested in fast rewards, choose small timeframes. If you would like to trade for longer, choose a long one (from H4).
- Predict the direction. Above, you can find the factors that affect the index direction. Additionally, you can use technical indicators. Indicators don’t differ from the forex market. We recommend using Awesome Oscillator, MACD, Momentum, and Volumes.
- Open a position. The last step is to open a position. Just click buy or sell, and you are in the market. Remember about pending orders that allow you to open a position at the price you want.
Here are some tips on using strategies in your trading activity.
It’s a simple strategy that will suit those who want to receive rewards fast and are ready to spend lots of time in front of the computer. The idea is clear: you open and close positions within one day. Thus, you aim to catch significant market movements. A considerable fluctuation may happen on big economic releases and news.
Therefore, to use this strategy, you should be equipped with lots of news publications, an economic calendar, and the time that you will spend. It’s recommended to trade on timeframes smaller than H1 to catch more significant price performance.
Trade On News
This strategy relates to the previous one. All you need to do is to determine what companies have the most significant weight on the index value. The most important event for any company is the quarterly earnings release.
Traders use analysts’ predictions and actual release data to trade on their difference. If the actual data beats the expectations, the stock’s price will rise. Thus, the index will appreciate. If the actual figures are worse than the forecast, the shares will depreciate, the index will go down.
If you know how to place support and resistance levels correctly, you can use this strategy. Thus, you buy when the index price breaks above the resistance with significant volumes. You sell when the price breaks below the support.
To sum up, a stock market index is your perfect match if you want to enter the stock market but fear the high volatility. An index smooths stock prices’ fluctuations, as it consists of many stocks. In general, an index reflects the health of an industry or economy to which it relates. The best way to trade a stock index is to use CFD.
If you feel you have doubts about what index to trade or how index trading takes place, use a Libertex demo account. This account will allow you to try index trading for free. Also, you can test your own trading strategy to improve it.
Do you have any questions left? Then here are the answers.
What Is a Stock Index Example?
There are some well-known examples of stock indices. They are the S&P 500, Nasdaq Composite Index, and Dow Jones Industrial Average.
How Is the Stock Index Calculated?
Every index has its own formula. However, most indices are calculated as the weighted average. Thus, you take the price of an equity, then multiply it by the number of shares, and divide the result by all stocks’ market capitalization.
What Are the Best Indices to Trade?
It’s always better to trade leading indices as they provide more substantial liquidity. The most famous are the S&P 500, DJIA, DAX, and the Nasdaq.
How Do I Trade Indices Like a Pro?
It’s easy to trade indices if you are familiar with forex or commodity trading. Check the stocks that make up the index, follow the news regarding the country or industry the index relates to. Use technical indicators such as Volumes, Momentum, and MACD. And practice a lot. Use a demo account to improve your skills.