a beginner’s guide
If you’ve ever watched the evening news, you might have noticed a quick reference of closing indices prices – but what exactly are these indices?
Indices (plural of ‘index’) track the performance of a specific group of stocks. This group of stocks either belongs to a particular market sector or represents a whole market.
For instance, the Dow Jones Industrial Average index tracks the performance of 30 companies listed on various US stock exchanges. Elsewhere, the DAX 30 tracks the performance of the 30 largest companies listed on the Frankfurt Stock Exchange (FSE).
An index goes up in price if the overall value of its stocks increases, and the price goes down if its overall stocks value decreases.
You can’t buy a whole index, but you can trade them as CFDs, which allows you to speculate on their price movements.
What’s the difference between market-weighted and price-weighted indices?
In a price-weighted index, the stocks with the highest prices have the most influence, regardless of the underlying company’s size.
In a market-weighted index (also known as a cap-weighted index), the stocks with the highest market value impact the movement of the prices.
Five major indices you should know
The word ‘industrials’ in the index name shouldn’t be taken too literally, as many of the companies in the index today come from sectors other than heavy industry (which the Dow once specialised in).
Although it’s one of the most followed equity indices, some traders believe that the Dow is a poor representation of the overall US market. This is because other broader market indices include way more companies, such as the S&P 500 or the Russell 3000, while the DJIA includes only 30. However, these 30 companies are also the most influential, which is definitely significant!
The Dow Jones is a price-weighted index and comes with an investing strategy unique to it: Dogs of the Dow. The general idea is to invest in the 10 highest dividend-paying blue-chip stocks among the 30 components of the DJIA.
S&P 500 is the most widely known stock market index. It is weighted by market capitalisation and is a benchmark of the US equities in the US economy’s leading industries. The index tracks 500 large-cap US stocks from companies circulating $5 billion or more in the stock market, including the 30 DJIA stocks. Like the Dow, it represents the stock market’s performance.
As with other indices, the S&P 500 is extensively used as a benchmark in determining a stock's investment performance and the best indication as to the health of the overall US stock market and economy.
S&P 500 makes up most of the market (about 80% of the overall market's value), while Its 10 most significant components comprise more than 21% of the Index.
The DAX 30, otherwise known as GERMANY 30, contains 30 German stocks listed on the FSE and is weighted by market cap. DAX 30 is one of the blue-chip stock indices, including FTSE 100 in the UK and the S&P 500 Index in the US.
DAX has followed the trends of other indices during significant events throughout history, including the COVID-19 pandemic. The German index also plunged in 2008 amid the global economic crisis.
The FTSE 100 tracks the 100 largest public companies by market cap listed on the London Stock Exchange (LSE). FTSE stands for Financial Times and the LSE, which initially formed the joint venture of being the index’s owner.
The Footsie, as investors love to call it, represents more than 80% of the LSE's market capitalisation. The UK 100, born in 1984, is the UK’s answer to the US Dow Jones. Its components are reviewed quarterly.
The US100 looks at the 100 largest non-financial companies’ market capitalisation, both domestic and international, listed on the Nasdaq stock market. There is a unique Nasdaq index hosting the financial companies named NASDAQ Financial 100.
Both of the above indices are sometimes confused with the Nasdaq Composite, i.e., “the Nasdaq”. Nasdaq, along with the Dow Jones and the S&P 500, are the three most broadly followed indices among the 5,000 indices of the US equity market.
Indices are a popular investment option because they offer exposure to a basket of stocks which, typically, the average trader would not be able to afford!
Traders can also use indices to:
- Analyse the return on different financial instruments
- Get a feel of how well a specific market performs
- Track the overall health and performance of an economy
- Getting exposure to the wider stock market even in the case of volatility of a certain stock.
- Trading portfolio diversification from any one stock’s volatility while maintaining exposure to the wider stock market.
- Ideal for day trading, swing trading and trend-trading strategies.
- Right after the opening bell or just before the closing bell. Typically, at the end of the trading day, there is high stock market volatility.
- Following the announcement of global news events or the release of key economic data triggering the movements in trading indices.
- When the EU and US stocks markets sessions – the two major trading centres – overlap, resulting in high liquidity.
As with all stock prices, the value of an index itself is affected by the performance of the companies’ constituents and macroeconomic factors. Indices react directly to major global or regional political, market and economic events such as interest rates, market expectations or even natural disasters.
Friendly reminder: The trend is not your friend. Seeing how indices have already performed — ie, the ‘trend’ — will not help you speculate on how indices will perform in the future. For example, if Dow Jones has been climbing for the last three weeks, this does not mean that it will continue to do so forever.
How do I trade
By taking a CFD position, a trader essentially agrees to exchange the difference in the price of an index from one time period to another. CFD trading also allows traders to take advantage of leverage, which means you can open up a trade with just a fraction of its total value (the rest is ‘borrowed’ from your broker). But make sure you approach leverage with caution! While it can magnify your gains, it can also magnify your losses.
Traders can go either long or short on an index:
- If you think the stocks in an index market are likely to go up, you can go long.
- If you think the index is going to decrease in value, you can go short.
If you’re new to indices CFD trading, why not sign up for a demo account? That way, you can trade virtual money at no risk to your finances.
As the old saying goes, an investment in knowledge pays the best interest – and at Eurotrader, we’re all about good investments.
Learn to trade and develop your skills with Eurotrader Academy. We’ve got plenty for you to watch and read so you can master the markets and make better-informed trading decisions.