Stock indices are constantly tracked by investors and traders to assess the health of the equity markets. Popular indices include the Dow Jones and the NASDAQ in the US, and the FTSE 100 in the UK.
There can also be multiple indices associated with one exchange. For instance, the FTSE 100 includes only the biggest 100 stocks listed on the London Stock Exchange, in terms of market capitalisation. But there is also the FTSE 250 index, which includes the next 250 stocks. There is also the FTSE All Share index, which includes all the listed stocks.
What are indices?
That still leaves the question of what are indices, really? They consolidate the price performance of stocks listed at specific exchanges. This makes it easy to figure out the mood of the markets at a given time. If indices are falling, it could be because the general sentiment on the economy is weak. Similarly, fast rising indices indicate that investors are optimistic about it.
Global indices might or might not move in tandem. It can happen that there are specific indices that underperform at times of political and economic changes. A good example is the FTSE 100’s weak performance after Brexit vote, compared to other indices. On the other hand, the ending of lockdowns, led to a broad rise over time in stock indices across the world.
How to trade indices
There are two ways to trade indices. The first is through exchange traded funds (ETFs). ETFs track the performance of the broad indices by investing in the stocks that constitute them. The second is through contracts for difference (CFDs). These are derivative products that allow traders to buy and sell based on whether they expect the index to rise or fall.
These financial instruments can be accessed through brokers. All leading brokers offer ETF products and many offer the option of trading CFDs as well. It is easy to set up a trading account with them. Once you choose which product you want to trade in, they can execute the trade for you.
What to know when trading indices
Investors and traders alike follow developments in economies and companies to assess what is next for indices. Specifically, the following can be tracked to decide where to put in your money:
- Macroeconomic data and events: From economic growth to inflation, these data can affect investor mood. A really high inflation print implies the likelihood of less consumer spending. This can depress demand and show up in companies’ financials. So indices can slide down based on anticipation of this development.
- Policy changes: Economy wide developments like increased public spending by governments can impact indices positively. This is of course because the stocks they represent can get a boost from the increase in demand such a spending can entail. Similarly, tax cuts can reduce costs and increase profits.
- Companies’ financials: It can also be useful to look at financials of companies that have a high weight in the index. Their health can have an outsized impact on index movements, so if they are doing well the index is likely to rise.
Benefits and limitations of trading indices
As opposed to individual stocks, index trading allows taking positions based on the general direction of the market. This means that you do not have to pick and choose specific stocks that make up the index. So if there is a piece of news that affects the entire market, you can simply buy or sell the index. It also incurs lower transaction cost as compared to trading in multiple individual stocks.
It is not without its limitations, however. If there is a development that affects only specific stocks, then you will not benefit entirely from an index investment. Consider the example of property stocks. If interest rates were to be reduced drastically, they are likely to rise fast as real estate is often purchased on mortgage.
If you had bought these stocks, the gains would reflect in the value of your portfolio. On the other hand, if you only bought an index, the positive impact would be blunted. Other stocks, like those in technology or pharmaceuticals, might not benefit as much. So they are unlikely to be as impacted. Since the index gains in line with the price changes of all stocks, your gains from index investments would then be limited.
Fit investments to suit you.
Ultimately, though, whether or not to invest in an index tracker depends on your requirements. If you are already savvy with the stock markets, you can easily pick and choose stocks that can give you maximum returns. On the other hand, if you do not have the capacity to do so, indices might be the way to go. If you do decide to trade in them, it is an easy, and potentially profitable option, however.