Introduction to financial markets
Trading an index can involve taking a position on hundreds of stocks at once. In this lesson, we cover how indices work – and the ways you can start buying and selling them.
- How do stock indices work?
- Market capitalization vs price-weighted indices
- Indices checklist
- What moves an index?
- How can you trade an index?
How do stock indices work?
An index is made up of numerous shares. And it is the performance of these shares that determines the value of an index.
However, there’s a little more to it than that.
Different indices are run by different organizations: such as banks or specialist index providers. The NYSE, for instance, is managed by Intercontinental Exchange. Each index has its own individual criteria for which shares should be included in it – chosen either by committee or its own methodology.
They also have different ways to measure how the daily price of an index is calculated. However, there are two main types of calculation: by market cap and price weighted.
Market capitalization vs price-weighted indices
Market capitalization indices
Market capitalization indices use the total market value of a company’s outstanding shares to assess how much it affects the index. This means that more valuable companies will have more of an impact on the index’s daily movements.
Most stock market indices are calculated using this method.
Examples: S&P 500, FTSE 100, NASDAQ
Price-weighted indices use a company’s share price to determine how much it moves the index. This means that companies with higher share prices will have a greater influence on these indices.
To calculate the value of a price-weighted index, you add the share price of each stock together and divide by the total number of stocks.
Examples: Dow Jones, Nikkei 225
Please note that the composition of an index is not set in stone and will change from time to time.
Before you trade an index, it’s a good idea to make sure you know:
- Which companies are in the index
- How often the index is changed (known as rebalancing)
- The rules for companies for being added or removed
What moves an index?
A stock index’s price is determined by the movements of the shares it tracks. Here are a few factors to watch out for when deciding what might move stock markets:
The political climate. Politics can have a significant impact on stocks. Elections can mean a change of policy that could bring headwinds or tailwinds for business, international tension could bring tariffs and more.
Company announcements. A new CEO, merger or earnings release at a key stock will often play out on the index it tracks.
Economic data. Employment data, central bank announcements and inflation rates all offer clues to how an economy is performing – and demand for shares in strong economies is often higher.
Industry news. If a headline impacts several large companies in a sector – e.g. mining or banking – then expect it to impact their broader index too.
How can you trade an index?
Unlike shares and forex, an index is just a calculation – there’s no actual asset to buy and sell. However, several financial derivatives exist that let you take a position on index prices without requiring you to buy 100 or more stocks.
On the FOREX.com platform, for example, you can trade over 15 of the world’s indices as a CFD.
Trading the Dow with FOREX.com
Let’s take a look at a working example. Open your FOREX.com demo to follow these steps and open a practice trade.
You’ve heard news that two major companies are considering a merger. As a result, you think the Dow Jones will rise, so you decide to take a long position on Wall Street.
Search for Wall Street in the platform and click the market to open a deal ticket.
You can choose to buy or sell Wall Street. Buying will give you a position that makes money if Wall Street rises, selling will earn you profit if Wall Street falls.
The number of CFDs you trade dictates how much profit or loss you make. Buying a single CFD will earn you $1 each time Wall Street moves one point.
If Wall Street gains 50 points and you close your position, then you will earn (50 x 5) $250. However, if it falls 50 points, then you would lose $250.
To close your position, you make a trade that is the opposite to when you opened. We bought five CFDs at the outset, so now we can sell five Wall Street CFDs to realize any profits or losses.
Test your knowledge
- A It's measured on how much money it has
- B It uses each company’s share price to determine its value
- C It sets its own price
- A Market capitalisation index
- B Price-weighted index
- A The index committee
- B The index itself