Index Trading

Trading indices allows you to gain exposure to hundreds of stocks at once. This lesson will cover how indices work and the ways you can start buying and selling them.

1. How do stock indices work?
2. Market capitalization vs. price-weighted indices
3. Index checklist
4. What drives an index?
5. How to trade indices?

How do stock indices work?

An index consists of multiple stocks, and their performance determines the index's value.

However, it's a bit more complex.

Each index is managed by various organizations, such as banks or financial service providers. For instance, the NYSE is managed by Intercontinental Exchange. Each index has its own criteria for determining which stocks to include, defined either by a committee or a specific methodology.

Indices also use different methods to calculate their daily value. The two most common approaches are market capitalization weighting and price weighting.

Market capitalization vs. Price-Weighted Indices

Market Capitalization Indices

Market capitalization-based indices use the total market value of the companies in the index to determine their impact on the index's overall movements. Larger companies with higher market value will have a greater influence on the index's daily changes.

This calculation method is used for most stock indices.

Examples:

• S&P 500

• FTSE 100

• NASDAQ

Price-weighted indices

Price-weighted indices determine the influence of individual companies on the index based on their stock prices. Companies with higher stock prices will have a more significant effect on these indices.

To calculate the value of a price-weighted index, sum up the stock prices of all the companies in the index and divide them by the total number of stocks.

Examples:

• Dow Jones

• Nikkei 225

Note:
The composition of an index is not fixed and may change over time.

Index checklist

Before trading indices, ensure you understand the following points:

• Index composition: Which companies are included?

• Frequency of changes: How often is the index reviewed (known as rebalancing)?

• Rules for adjustments: What criteria are used to add or remove companies from the index?

What drives index values?

The price of a stock index changes based on the movements of the stocks it tracks. Consider these factors when assessing what may influence stock markets:

1. Political climate:
Political events can significantly impact stock values. Elections may lead to policy changes that can either benefit or hinder businesses. International tensions can result in tariffs or other trade restrictions.

 2. Company announcements:
Key events, such as appointing a new CEO, mergers, or earnings reports from major companies, often affect the value of the indices that include those stocks.

3. Economic data:
Indicators like employment figures, central bank announcements, or inflation rates provide insight into the economy's health. Strong economies typically see higher demand for stocks.

4. Industry news:
Major headlines impacting several large companies within a sector (e.g., banking or mining) can also influence the broader index that includes them.

How to trade indices?

Unlike stocks or forex, an index is merely a calculation—it does not represent a physical asset you can directly buy or sell. However, several financial derivatives allow you to take a position on index price movements without owning hundreds of individual stocks.

For instance, on the FOREX.com platform, you can trade over 15 global indices via CFDs (Contracts for Difference).

Example of trading Dow Jones 

Scenario: You hear that two major companies plan to merge. You believe the Dow Jones index will rise, so you decide to take a long position on Wall Street.

Finding the Market: Locate the Wall Street index on the platform and click on its name to open the trading ticket.

Deciding to Buy or Sell:

Buy: If you expect the Wall Street index to rise, you take a position that profits as the index increases.

Sell: If you expect the index to fall, you take a position that profits as the index decreases.

Determining trade size: The number of CFDs you trade determines your potential profit or loss. For instance, buying one CFD means gaining or losing $1 for every point the Wall Street index moves.

Example:

• If the Wall Street index gains 50 points and you close your position, your profit will be (50 x 5 CFDs) $250.

• However, if the index falls by 50 points, your loss will be $250.

• Closing the Trade: To close your position, execute the opposite trade to the one you opened. If you initially bought five CFDs, you now sell five CFDs on Wall Street to realize your profit or loss.