What is a Stock Index?

A stock index is a statistical measure designed to track the performance of a basket of selected or related stocks. Most countries have broad market indices, such as the US S&P 500, which reflects the collective value of the top 500 companies listed on U.S. stock exchanges; or specialised indices that cover specific sectors or industries, such as financials or technology.

An index price usually reflects the average performance of individual stocks that make up that index. When the price of an index goes up, it means that most of its constituent stocks have increased in value compared to a minority that has dragged it lower.

Unlike stocks, indices cannot be purchased directly. Investors trade indices by buying index funds or stock index CFDs.

When buying an index fund, the relevant investment firm will allocate capital to various stocks constituting any underlying index. Index funds are often touted as cheaper alternatives to other active management funds, and they can expose investors to consistent returns over time.

When trading stock index CFDs, investors simply speculate on the price changes of an underlying index. CFDs are particularly attractive for traders because they are leveraged products, and profits can be made on both rising and falling prices.

In addition to big indices, such as the S&P 500 and DJIA, there are also indices that represent smaller companies trading on the NYSE, such as the Russell 2000 index, as well as indices for various stock exchanges around the world, from Chinese China A50, Japan’s NIKKEI to Germany’s DAX and Dutch AEX.

Indices have numerous practical investing advantages over individual stocks. They are highly liquid owing to the amount of activity that takes place in individual constituent stocks. This means that they can provide volatility even for day traders looking to take advantage of intraday price fluctuations to make a profit.

Additionally, indices are the best reflection of the broad economic effects of both political and economic shifts, making them the best assets for implementing news-based strategies.

Indices also expose investors to an entire stock exchange, country or industry. Investors just need to express a broad market view by taking either a bullish or bearish position, depending on prevailing market sentiment.

Another advantage of trading indices is that they are generally considered safer than individual stocks. The number of constituent stocks means that no single company can sharply influence the overall price of an index.

This makes indices the least reactive assets, with price action relatively smooth, as well as more stable and predictable. Indices offer such safety that significant losses in any one of them are considered big news in the market.

For risk-averse and longer-term traders, index investing allows for easy and effective diversification. Instead of investing in just a few stocks, where risk is magnified, index-based ETFs offer exposure to the entire stock market index, while simultaneously reducing the risk of a single company negatively impacting your entire trading portfolio.

Indices are usually created and maintained by financial institutions, exchanges, or even by specialised data firms. There are various ways of calculating the prevailing price of a stock index, here are 3 common forms:

1. A price-weighted index is calculated in such a way that constituent companies with the highest share prices carry significant weight in the index. The DJIA (Dow Jones Industrial Average) is an example of a price-weighted index.
2. A capitalisation weighted index is calculated in such a way that constituent companies with the biggest market capitalisation carry significant weight in the index. The S&P 500 is an example of a capitalisation-weighted index.
3. An unweighted index is calculated in such a way that individual stocks carry equal weight in the index. KCBT (Kansas City Board of Trade) is an example of an unweighted index.

While those are three broad methods of calculating stock market indices, a number of variations can be applied to achieve different objectives.

Some indices use a divisor or a modifier to reduce the impact of the largest stock(s) in an index, while other capitalisation methods will only consider free-floated stocks (stocks available for trading in the public).

Factors that Influence Index Prices

The composition of indices means that prices can be influenced by various drivers. Here are some of them:

1. Economic News

Indices are generally driven by market sentiment because of their broad composition. Major economic news and events that drive market sentiment, such as central bank announcements, employment, and wage numbers as well as industry-specific headlines, such as mining numbers, can drive the prices of indices.

2. Company Announcements and Events

Important announcements and events of particular companies that carry significant weight in their respective  indices can also drive prices. These can be earnings reports, leadership changes, or even possible buyouts or mergers.

3. Commodity Prices

Prices of commodities, such as oil, have a direct or indirect influence on economic performance in many countries. As well, the composition of many major indices consists of companies whose bottom lines are impacted by international prices of various commodities. This means that fluctuations in the commodity market can also have an impact on various major indices.

4. Changes in an Index’s composition

Most indices are rebalanced periodically, with new companies getting included while others are removed. Indices can see their prices fluctuate as investor sentiment is driven by this inclusion and removal of companies.

Why Trade Index CFDs instead of Index ETFs?

Index ETFs (exchange-traded funds) represent units of ownership of underlying stocks or bonds. They are similar to mutual funds and are traded on exchanges.

They have always offered investors the practical advantage of investing in indices: diversification, high liquidity, low fees, and passive investment. Index ETFs are ideal for highly capitalised investors that seek small but steady profits over a long period.

On the other hand, index CFDs allow investors to speculate on the price direction of an underlying index. When trading Index CFDs, investors experience the practical advantages of index ETFs, plus more.

Index CFDs are leveraged products, which means that traders only need to place a small margin to control a bigger trade position in the market. Leverage ensures profits are magnified, but it can also amplify trade losses.

Leverage also ensures that traders can still make big profits out of small price changes in the market, which makes index CFDs ideal for short term trading strategies, such as day trading or scalping.

When trading index CFDs, investors earn profits by predicting the price direction, which means that money can be made whether prices are rising or falling.

At Wealth Finance Limited, you can trade major indices around the globe with a leverage of up to 400:1. We also offer low spreads and no restrictions on trading strategies, such as hedging or short trading.

How Can Wealth Finance Limited Help You?

You can visit the Education section to learn more about CFDs. There are numerous eBooks and guides on indices trading strategies as well as market analysis videos and regularly updated blog posts. We also offer scheduled weekly webinars conducted by top industry professionals and investors as well as real-time stock market indices in-chart technical analysis updates by Trading Central! Everything you need to trade indices CFDs more accurately can be found at Wealth Finance Limited.

Make Wealth Finance Limited your CFD broker and enjoy the benefits of trading with a regulated, award-winning broker!