Financial markets are rich in instruments you can trade. One of those key instruments is indices, which are often used as a way to measure the performance of an overall market. For example, the Dow Jones measures the performance of the biggest industrial companies in the United States, and the NASDAQ shows you how well technology companies are doing.
Indices are effective tools for measuring the pulse of the market because each index is an aggregate of several instruments contained in it. As such, investors do not need to check the performance of every single stock in the index. They can just look at the index to get a feel of how the whole industry is doing.
How do indices work?
As a rule of thumb, an index includes a basket of assets grouped together. The index is usually measured in points, and its movement depends on the movement in underlying securities. Oftentimes, some securities have more weight in an index than other securities. For example, in the S&P 500, companies with bigger market capitalization have a bigger weight in the index, and thus movements in the stocks of those companies tend to be a lot more impactful on the index as a whole. Companies with smaller market capitalizations have a limited impact on the index.
Each index has its own methodology to calculate points and movement, and thus as an investor understanding this methodology is essential for indices trading.
What types of indices are there?
There are several types of indices as mentioned below.
1. Benchmark indices
The most well-known indices usually help you assess the performance of a single country. For example, the FTSE 250 helps you understand the performance of the UK stock market, and the Dax helps you understand how the German stock market is doing. Those are called benchmark indices because they serve that very purpose.
2. Sectoral indices
Sectoral indices help you get a macro view of a specific sector. For example, agricultural indices help you see whether the agricultural sector is growing or contracting. The same applies for real estate indices, and industrial ones.
3. Market-cap based indices
Some indices include only small companies with small market capitalization (below $2 billion in some cases), whereas other indices aggregate the performance of companies with big market capitalizations. Each set of stocks are perceived to have varying levels of risk. Companies with bigger market capitalization are considered to be more stable since they have bigger cushions to tolerate bad economic conditions.
How to trade indices?
An index is not a security, but rather an indicator for the performance of a group of securities. As such, you cannot trade the index itself. However, you can trade CFDs on an index if you have a reliable broker. Those CFDs give you the exact same exposure and benefits.
Indices give you a higher-level view of the market. They are useful for investors and traders who want to see how different industries and sectors are doing. This can help investors make better decisions and protect themselves from investing in sectors that are facing a downturn.