Trading stock indices

How are major stock indices calculated?

Most major indices are either calculated using a capitalisation-weighted or a price-weighted system.

Capitalisation-weighted system

Used by the majority of stock indices, this system takes the size of each company into account when calculating the value of the index as a whole. So, the more a particular company is worth, the more its stock price will affect the index.

You can calculate a company's market capitalisation by multiplying its stock price by the number of shares issued. This is called its market capitalisation.

The FTSE 100 is calculated using this method. So if, for example, BP is valued at twice the size of Barclays, any change to BP's stock price will have twice as large an effect on the FTSE 100 as a similar change for Barclays.

Indices that use the capitalisation-weighted system include:

• S&P 500
• Nasdaq-100
• Hang Seng
• CAC 40
• IBEX 35
• MSCI Emerging Markets
• ASX 200, and more

Price-weighted system

This method is based on the actual stock price of the companies in the index, rather than their overall size.

The higher the stock price, the more influence that company has on the value of the index. For example, a stock trading at $100 would have five times more clout than one trading at just $20.

The only two major indices that use the price-weighted system are:

• Dow Jones Industrial Average
• Nikkei 225

What moves an index's price?

An index's price can be affected by a range of factors, including:

• Economic news – investor sentiment, central bank announcements, payroll reports or other economic events can affect underlying volatility, which can cause an index's price to move
• Company financial results – individual company profits and losses will cause stock prices to increase or decrease, which can affect an index's price
• Company announcements – changes to company leadership or possible mergers will likely affect stock prices, which can have either a positive or negative effect on an index's price
• Changes to an index's composition – weighted indices can see their prices shift when companies are added or removed, as traders adjust their positions to account for the new composition
• Commodity prices – various commodities will affect different indices' prices. For example, 15% of the shares listed on the FTSE 100 are commodity stocks, which means any fluctuations in the commodity market could affect the index's price. In the Middle East, movements in oil prices can also influence regional indices such as the DFM General Index or Tadawul All Share Index (TASI).

How do you trade stock indices?

Since indices are effectively just numbers, you can't buy or sell them directly. There's no asset to own and nothing to exchange. Therefore, to trade on the price of an index, you need to choose a product that mirrors its performance.

Let's explore the options in detail:

Index fund

A specialised investment fund that attempts to replicate the movements of a particular stock index. You can invest in index funds through a fund manager.

Exchange-traded fund (ETF)

A distinct type of index fund that can be traded like a stock on an exchange. Just like stocks, the price of ETFs can change throughout the trading day as they are bought and sold. Currently the largest ETF in the world is the SPDR S&P 500 which, unsurprisingly, tracks the S&P 500.

Derivatives

Financial products that derive their price from the performance of an underlying instrument. For example: futures, options, digital 100s or contracts for difference (CFDs). Explore IG's CFD platform here.

Now that you understand what stock indices are and how they reflect market performance, you can start exploring how to trade them. Whether you're interested in the FTSE 100, S&P 500 or Nasdaq-100, practising with a demo account lets you get comfortable with index trading before committing real funds.