What are indices and how do you trade them?

What are indices?

Indices are a measurement of the price performance of a group of shares from an exchange. For example, the FTSE 100 tracks the 100 largest companies on the London Stock Exchange. Trading indices enables you to get exposure to an entire economy or sector at once, while only having to open a single position.

You can speculate on the price of indices rising or falling without taking ownership of the underlying asset with CFDs. Indices are a highly liquid market to trade, and with more trading hours than most other markets, you can receive longer exposure to potential opportunities. Start trading indices today with an IG account.

How are stock market indices calculated?

Most stock market indices are calculated according to the market capitalisation of their component companies. This method gives greater weighting to larger cap companies, which means their performance will affect an index’s value more than lower cap companies.

However, some popular indices – including the Dow Jones Industrial Average (DJIA) – are price-weighted. This method gives greater weighting to companies with higher share prices, meaning that changes in their values will have a greater effect on the current price of an index.

What are the most traded indices?

1. DJIA (Wall Street) – measures the value of the 30 largest blue-chip stocks in the US
2. DAX (Germany 40) – tracks the performance of the 30 largest companies listed on the Frankfurt Stock Exchange
3. NASDAQ 100 (US Tech 100) – reports the market value of the 100 largest non-financial companies in the US
4. FTSE 100 – measures the performance of 100 blue-chip companies listed on the London Stock Exchange
5. S&P 500 (US 500) – tracks the value of 500 large cap companies in the US

How to identify 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 share prices to increase or decrease, which can affect an index’s price
• Company announcements – changes to company leadership or possible mergers will likely affect share 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

Why trade indices?

1. Go long or short
2. Trade with leverage
3. Hedge your existing positions

Go long or short

When index trading with CFDs, you can go long or short. Going long means you are buying a market because you expect the price to rise. Going short means you are selling a market because you expect the price to fall.

With CFDs, your profit or loss is determined by the accuracy of your prediction, and the overall size of the market movement.

Trade with leverage

CFDs are leveraged products. This means you only need to commit a small initial deposit – known as margin – to open a position that gives you much larger market exposure.

When trading with leverage, you should remember that your profit or loss is calculated using the entire position size, not just the initial margin used to open it.

Hedge your existing positions

An investor with a collection of different shares might short an index to protect themselves from losses in their portfolio. If the market enters a downturn and their shares start to lose value, the short position on the index will increase in value – offsetting the losses from the stocks. However, if the stocks increased in value, the short index position would offset a proportion of the profits which had been made.

Alternatively, if you had a current short position on several individual stocks which feature on an index, you can hedge against the risk of any price increases with a long position on that index. If the index rises, your index position will earn a profit, counteracting a proportion of the losses on your short stock positions.

How to trade indices

1. Choose how to trade indices
2. Decide whether to trade cash indices or index futures
3. Create an account and log in
4. Select the index you want to trade
5. Decide whether to go long or short
6. Set your stops and limits
7. Open and monitor your position

Choose how to trade indices

With IG, you can use CFDs to trade indices. CFDs are financial derivatives, which means you can use them to speculate on indices that are rising in value, as well as falling.

CFDs

CFDs are a contract between two parties to exchange the difference in price from the point at which the contract is opened, to the point at which it is closed.

Cash indices

Cash indices are favoured by traders with a short-term outlook – such as day traders – because they have tighter spreads than index futures. Cash indices are traded at the spot price – which is the current price of the underlying market.

Many traders will close their cash indices positions at the end of the trading day and open new positions the following morning to avoid paying overnight funding charges.

Index futures

Index futures are often preferred by traders with a long-term market outlook. This is because, while they have wider spreads than cash indices, the overnight funding charge is included. Index futures are traded at the futures price – the price that futures traders agree in the present for delivery in the future.

If you plan on holding on to an index position for a long time, trading index futures will mean that you don’t incur frequent overnight funding charges.

ETFs and shares

Aside from cash indices and index futures, you can also trade index ETFs and individual shares with IG. Again, you can open these positions with spread bets and CFDs. If you’d rather take ownership of the underlying market, you can also invest directly in index ETFs and individual shares with IG.