Several investors are searching for different ways to trade indices and improve their strategies when they gain exposure to the markets. But how to trade indices? Are they traded in the same way as equities and other financial instruments?
The short answer is yes. You can trade indices using your local broker as long as it supports indices. Of course, there are some portfolios that would fit better to indices than others and that would need some sort of diversification. Hence, if you want to know how to trade indices, you should know that they are not for everyone.
In the next few sections, we will share with you how to trade indices, what they are, and why they are important for every type of investor. Moreover, we include a list of the most popular indices in the market and what you can do to trade them on a regular basis.
What are Indices?
Indices are a measurement of the relative movement of shares. These shares tend to have something in common that allow them to be grouped together. They can be classified by type: price or volume. The main indices are the Dow Jones Industrial Average, Barclay’s Capital Aggregate Bond Index, and the Standard & Poor’s 500 (S&P 500); but there are many other indices in financial markets that investors use every single day.
Indices are a way to compare the value of different securities in terms of their relative movement. Popular among traders, watch-list and active investors tend to use indices as reference points to keep track of the market movements. They can give very accurate information about the market, about the trend of a specific industry, and more.
Each index is composed of a group of stocks selected for the purpose of representing a particular market or industry. These stocks are usually weighted in some way according to their size or importance in the industry.
For example, companies with the greatest influence on their industry’s stock price are given more value in the index than companies whose influence on company price is smaller (or not as significant). The values of all the stocks relative to each other (based on trends and fluctuations) represent that market’s movement. Hence, indices can fluctuate and change according to different market and industry trends.
An example of an index can be found given by the Dow Jones Industrial Average (DJIA), composed of 30 large and important U.S. companies, representing the performance of the U.S. stock market as a whole.
Thanks to the fact that indices are now very popular, it is possible to understand how a specific market behaves compared to individual stocks. These indices are usually based on averages that give the market and investors an idea of how the market behaves. Furthermore, these indices can be a great way for investors to diversify their portfolios without having to be worried about selecting individual stocks.
Popular Indices in the Market
There are many different indices in the market. Indeed, most countries and large markets have indices that let investors track the performance of different sectors and industries. There are indices that track the performance of technological companies, while other indices track the performance of companies of a specific region or country. In this post, we will only share with you some of the largest indices in the world and how they work, but there are many other indices in the market.
You can trade many other indices that we do not include in this list. This is just for educational purposes only and you should analyse which is the index that suits better to your needs.
The S&P 500 is perhaps the largest index in the market in terms of adoption and recognition. This is usually the index taken as a benchmark to understand the whole performance of the market on any given day. If the S&P 500 moves higher, this could be considered a good sign. If it moves lower, then we need to know what’s going on.
S&P 500 stands for Standard and Poor’s 500. Traded in the United States, this index tracks the performance of 500 publicly traded domestic companies. Thanks to the fact that it includes many companies, investors that want to trade it don’t have to be worried about stock diversification. It usually includes a wide range of stocks from different companies and sectors.
Of course, it is worth considering that indices should be added to an already diversified portfolio rather than composing an investment portfolio just with an index. Another important thing to mention about this index is that it includes companies across 11 different industries and gives clear information to investors.
While using an index to trade, investors should also know that they follow a specific trend. If you trade these indices, you will not be able to outperform the whole market (as you are trading the index that is considered to be a market benchmark). If you want to outperform it, then you should diversify your portfolio, which adds more risk to your position but higher possibilities of winning.
Dow Jones Industrial Average (DJIA)
The Dow Jones Industrial Average (DJIA) is another popular and important index in the United States (US). This index shares information about the 30 most influential and largest companies in the country. Like the S&P 500, the DJIA is a very important index as it is used by financial outlets all over the world to understand what’s happening with the markets.
One of the things to mention is related to the fact that usually when investors want to know how the market is behaving, they go to both the DJIA and the S&P 500. This gives valuable information to investors, and it works as a way to have different views on the market. Traders have also been adding the DJIA to their investment portfolios as it is a great way to measure market performance and avoid large volatility.
If both the S&P 500 and the DJIA move downwards, then the market is clearly in a downtrend and there are some negative events that had an impact on most stocks. If both indices move higher at the same time, you should consider it a positive thing. Now, if one index trades in one direction and another index in the contrary direction, there might be some issues affecting some particular stocks and pushing the index down.
NASDAQ Composite Index
The Nasdaq Composite Index is one of the largest and most popular indices in the market. It is currently composed of 2,500 companies (even more at the time of writing) and it helps investors have a clear idea of how stocks behave in a certain period of time. When using the NASDAQ, investors will have detailed information about how the market moves considering that there are thousands of companies grouped in the NASDAQ Composite Index.
It is always a good thing to use the NASDAQ Composite Index and combine it with other indices and trading tools in order to have a clear idea of how the market behaves. This is the best thing to do if you want to reduce your chances of making an unprofitable trade. Using indices is always a good option, but when you have a clear overview of the market by analyzing different indices, then you will get all the information that you should have.
If you have been using the S&P 500 and the DJIA, then you can also add the NASDAQ to your analysis as well. This will offer you a more complete view of the market and how it behaves on a given day. Take into consideration that adding another index to your analysis will let you understand whether there are some issues affecting a specific industry.
All this information, however, would not be enough for you to know how to trade indices. You should search for a platform that would let you trade these indices. Another thing that you can do is follow and track them and invest in the best-performing stocks of each of these indices. This is one of the fastest and clearest answers on how to trade indices.
Let’s continue with the FTSE 100. This is one of the most popular and largest indices that focus on companies in the United Kingdom. The previous indices discussed in this blog post make reference to indices in the United States. Therefore, there is a difference between local indices and indices from other countries.
International traders and investors who search for investment opportunities in different markets usually analyze different indices. The FTSE 100 is one of the best ones in order to get clear information about the UK, one of the largest economies in the world.
This market-capitalization weighted index of UK companies is a great way to get a clear idea of how the London Stock Exchange is trading and which is the sentiment in the market. Combining this index with other indices in the European continent could be a great way to understand the market situation in Europe.
There are other indices that will let you analyse certain markets and countries. If you want to be more specific, some other indices will let you track the performance of a specific industry in a given country. This would be the best way to keep informed about possible market trends that would let you invest in specific stocks at the end of the day.
How to Trade Indices?
Now, the question that we need to answer is how to trade indices. There are many ways to do so. However, the goal is simple, we want to have exposure to some of the largest financial markets and indices in the world. This would help us get average returns for specific market segments and industries.
The thing that you should know is that you cannot trade indices without using derivatives. This happens because there is no such thing as a “traded index.” However, you can always trade futures or options that will follow the price of a specific index.
Therefore, derivatives will follow the price of the underlying index and give you the possibility to get exposure to them. Indices are basically a way to receive information about how specific markets are behaving. This is why you will not be able to trade them as stocks.
If you want to have exposure to certain markets, you can easily trade futures or options of a specific index. For example, traders that want to gain exposure to European markets can easily trade derivatives linked to indices in Europe. Hence, it is very important to understand what derivatives are and how they work.
Another thing that you can do is follow specific trends and indices and track their performance. Then, you can check which have been the best-performing stocks in these indices and invest in these companies. This could be a great way to increase your profits if the market continues to behave in the way it did. Moreover, this is an option for investors that want to “beat the market.”
But remember, there are no risk-free investment options. Every single time that you invest in indices or any type of stock, you should know that there is a possibility for your investment not to offer you positive returns. Therefore, diversification becomes important if you are learning how to trade indices.
Why are Indices Important?
Finally, why are indices important? What’s the real importance of trading indices from different countries and economies? The reality is that indices share with us a lot of valuable information. It might be easy to trade one or two different stocks. However, it is much more difficult to create a balanced portfolio that will include different assets and give us clear information about the market as a whole.
This is why indices help us get valuable information about the markets and the direction they are taking. Properly understanding this would be a key thing for traders to improve their trading strategies, build more balanced portfolios and get exposure to different sectors without having to select specific stocks that could offer good returns in the future.
If we want to gain exposure to a specific market or industry, then indices will be key. Why? Because we will get the chance to improve our chances of success. Despite the fact that we will have average returns for that industry (we reduce risk, but we also limit our profits), if we properly selected some of the most profitable markets, then there is a large possibility of being profitable.
Creating and building a balanced portfolio requires investors to include indices. This is why it is so important to analyze different trading tools and decide whether to add or not different indices to our investment portfolios.
If you are learning how to trade indices, then you should know that you will not be able to beat the market. Additionally, returns will be average market returns to which you should deduct the fees of your broker or agent. Indices are a great way to analyse the market and take decisions accordingly, but trading them or adding them to your portfolio are ways to reduce risk and reduce volatility.