What is Index Trading?
You can hear people talking about the stock market everywhere - on TV, radio, magazines and the internet. But what does it mean when we say "the market has performed well today"? What is "the stock market" anyway?
Very often, when most people talk about "the market", they talk about stock indices. With the growing importance of the stock market in our society, index names like the Dow Jones Index, SP 500, CAC40 or DAX 30 have become part of our everyday vocabulary.
Table of Contents
Index Trading: An Introduction
Most traders know the names and abbreviations of the main global stock indices, but perhaps not everyone is aware that these they can also be traded via CFDs. In fact, stock index CFDs can not only be analyzed, but they can also be bought and sold in a similar way to how stocks are traded.
What is a stock index?
The stock index itself represents the value of a group of stocks from one country, and shows the overall, current, and historic performance of that particular stock index. The FTSE100 index represents 100 companies listed on the London Stock Exchange with the highest market capitalization, while the S&P500 represents a broad range of 500 US companies.
Charles Dow created the first stock index in May 1896. The Dow Jones index included the 12 largest companies in the United States, and today the Dow Jones Index (DJI) contains the 30 largest and most influential companies in the United States.
Every stock exchange in the world and each country has a benchmark stock index, and some have several indices. As it would be close to impossible to track every stock in every country, stock indices allow traders and investors to measure the overall performance of a stock market or a country.
Economists, politicians, and analysts can use stock indices to understand how well the financial markets and companies in those markets are performing.
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How do stock market indices work?
As we discussed above, a stock index represents the performance of different entities, such as:
- A country, like the German Index DAX 30.
- A group of stocks within one country, like the S&P 500 from the US.
- A sector, like the Nasdaq index, which represents stocks (and companies) from the technology sector.
When it comes to how stock indices represent the value of a country, group or sector, if the value of the Nasdaq index goes up or down, that is an indication of the overall performance of all the stocks within the Nasdaq. When the price of the stock index increases, then the overall value of the index moves higher too. The same is valid for when the stock index is moving down, which means that the overall value of the index is decreasing.
The direction of the stock index, however, does not indicate that all the individual stock prices of the index are moving up or down. The average of all the stocks may be becoming more valuable, but while some stocks are going up, others could be moving down. The same is valid for a bearish day on the stock index: more stocks or sectors are likely to be bearish, but some might be bullish.
This raises the question of how is an index calculated?
Index Trading: How to Calculate Stock Indices
Before the digital era, calculating the price of the index was not easy. Today, most stock indexes use a weighted average formula to determine the value of the index. In this system, the weight of each share is:
Share price x number of shares / market capitalization of all shares
Most indices weigh companies by market capitalization. If the market capitalization of a company is 1,000,000 pounds and the value of all the shares in the index is 100,000,000 pounds, then the company would be worth 1% of the index.
This means the value of a stock index is a statistical measure of changes in a portfolio of shares that represents a part of the market.
Benefits of Trading Stock Market Indices
Stock indexes are an interesting alternative to other financial markets.
Here are some advantages of trading indices:
- Trade on the movement of the stock market as a whole
- Instant diversification compared to the stock market
- Trade a range of strategies over different time periods
- Indices are established markets with little possible price manipulation
- Trade markets that you know well: the FTSE100 in the UK, the SP500 in the US, the DAX 30 in Germany, etc.
- The option of long term trading
However, like any financial market, there are some disadvantages of stock index trading:
- Some stock indices are less liquid than other markets, like Forex
- Brokerage fees may be higher on less traded indices
- Trading hours are limited - while Forex can be traded 24 hours a day, 5 days a week, the stock markets are only open during local business hours
- Because the market closes, there may be more gaps than in Forex
Trading stock indices vs. investing in stocks
When comparing investing in traditional stocks with index trading, there are a number of reasons why someone might prefer index trading.
Investing in stocks means you are exposed to any risks facing a specific company. By contrast, investing in a stock index means you are automatically diversified, as your investment represents tens, if not hundreds, of stocks.
In addition, several studies have shown that investing in indexes is much more profitable than investing by choosing stocks individually. This is all the more true because the indices can allow you to diversify sectorally and even geographically.
If you trade stock indexes with CFDs, you can also benefit from leverage, which means you can trade with a deposit that is only a small percentage of the value of your investment. However, while leverage can multiply your profits, it can have the same effect on losses.
In addition, while you can only buy and hold a share in the hope of selling it for a higher price, a stock index CFD can be traded long (meaning you buy with the hope that it will increase in value and you sell for a profit), or they can be traded short (meaning you sell with the hope that the index will decrease in value, and then close your trade at a lower price, making a profit on the difference).
You could also argue that it is better to take a short position on a CFD (both stock CFDs and index CFDs) than it is to short a single individual share, as risk management parameters such as the stop loss are simple to implement within CFD trading. Limiting the risk on a trade setup is an important risk management tool.
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Index trading vs. Forex trading
Again, both markets have benefits and the right one for you will depend on your trading strategy. Forex can be challenging because you need to predict the movements of a single currency pair, which can be influenced by a range of factors, and can be highly volatile. By contrast, with index trading you can trade based on predictions about the broad movements of the market.
Forex trading is often suited to short-term scalpers who benefit from the high volatility and low spreads. Index trading, on the other hand, especially on indices with wider spreads, may be more suited to longer-term traders, like swing traders.
Another thing to consider is how well you understand the market. While some traders understand and can successfully trade a certain economy or sector - which is a good fit for index trading - others understand currency movements better, which means they are more suited for Forex trading.
Index Trading: Popular Stock Indices
There are stock indices all around the globe, but some are certainly traded on more than others. There are stock indices within the US, Europe, and in Asia.
Popular US stock indices
Three of the most well-known US stock indexes are popular with domestic traders: the Dow Jones Industrial Average (DJI30), the Nasdaq and S&P 500.
DJ30 - Dow Jones Industrial Average
The DJIA index comprises 30 companies: 3M, American Express, Apple, Caterpillar, Chevron, Cisco, Coca-Cola, DuPont, Exxon Mobil, General Electric, Goldman Sachs, JPMorgan Chase, Johnson & Johnson, McDonald's, Merck, Microsoft, Nike, Pfizer, Procter & Gamble, Travelers, UnitedHealth Group, United Technologies Corporation, Verizon, Visa, Walmart, and Walt Disney.
The DJIA index is getting more and more popular among traders, often with 3-4 periods of strong price movements between 8am and 10pm GMT. On January 17, 2020, the Dow Jones hit an all-time high of 29,401.40, following a consistent upward trend since March 2009.
Even though the Dow Jones is doing well at the moment, markets do have up and down cycles, and at times these can be quite strong. Throughout its history, this stock index has been moving up regularly and gradually, but there have been years and decades where it has experienced major booms, together with days, months and years with large drops.
Let's review some of the key moments for the stock markets:
- Wall Street Crash of 1929: the crash was created due to the speculative bubble in stocks. It lasted for four years.
- Black Monday in 1987: this crash occurred on one day and 22.61% was lost, and this is still the largest recorded drop on a single trading day. There were no clear reasons established for what caused the sudden crash, but program trading could have been a factor.
- Dot-com Bubble in 2000: technology stock prices were moving up very quickly between 1995 to 2000, and the speculative bubble eventually burst in 2000.
- The 'Great Recession' in 2008 (Or Global Financial Crisis): the financial system in the US was crumbling as banks, and other financial institutions felt the problems created by bad debts within the housing market, which were amplified by derivatives trades.
- The rise of the market since 2008: the stock markets have seen a remarkable rise ever since the Great Recession, marking a large bull run.
These downturns are why it's important for traders to have strong risk management in place.
SP500 - Standard and Poor's Index
The S&P 500 measures the performance of 500 large companies listed on US stock exchanges. Some of these include 3M, Adobe Systems, Alphabet, Amazon.com, American Express, Berkshire Hathaway, Boeing, Citigroup, Coca-Cola, eBay Inc, Exxon , FedEx, General Motors, General Electric, Goldman Sachs, Harley-Davidson, Hewlett Packard, Hilton, Intel, Johnson & Johnson, JPMorgan, Mastercard, McDonald's, Nasdaq, Nike, Oracle, PayPal, PepsiCo, Salesforce, Starbucks, Twitter, Visa, Walmart and more.
Like the Dow Jones, the S&P 500 hit all-time highs in January of 2020, hitting 3,337.55 on January 22. It has also experienced a strong upward trend since March 2009, following the end of the worst of the global financial crisis.
NQ100 - Nasdaq stock index
The Nasdaq 100 contains the 100 largest companies in the technology sector in the US. Unsurprisingly, the Nasdaq is one of the global indexes that we hear a lot about, and is highly regarded by stock index traders.
Some stocks represented by the Nasdaq 100 include: Adobe, Advanced Micro Devices, Alphabet Inc., Amazon.com, Amgen, Apple Inc., Autodesk, Cisco, Citrix, Ebay, Expedia, Facebook, Hasbro, Intel, Intuit, Marriott, Micron, Microsoft, NVIDIA , Netflix, Tesla, Workday, and more.
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How to trade US stock indices
If you'd like to trade the Dow Jones, S&P 500 or Nasdaq, getting started is simple. You'll need to:
1. Open a trading account with a CFD broker.
2. Download the MetaTrader 5 trading platform.
3. In the Market Watch window, in the 'click to add…' search bar, search for the code of the index you would like to trade. The three listed above are [DJI30], [SP500] and [NQ100]. You can then right-click the instrument to open the chart.
4. Open a Buy or Sell trade!
Popular European stock indices:
Some of the most popular European stock indices include the FTSE100 in the UK, the DAX in Germany, the CAC 40 in France and the Stoxx50, which represents a range of companies across the Eurozone.
The UK stock index - FTSE 100
The London Stock Exchange, one of the most popular stock exchanges in the world, also has its own stock index - the FTSE100. The FTSE (or Footsie) represents 100 companies from the London Stock Exchange, including:
3i, AstraZeneca, Aviva, BAE Systems, Barclays, BHP, BP, British American Tobacco, BUNZL, Diageo, easyJet, Experian, GlaxoSmithKline, Glencore, HSBC, Just Eat, Lloyds Banking Group, Prudential, Reckitt Benckiser, Rio Tinto, Rolls-Royce Holdings, Royal Bank of Scotland, Royal Dutch Shell, Tesco, Unilever, Vodafone Group, and so on.
The German stock index - DAX 30
The DAX is an index composed of the 30 largest companies on the Frankfurt Stock Exchange, based on their market capitalization and volume order books. The index is managed by Deutsche Borse and prices have been calculated every second since January 1, 2006 by the electronic system Xetra.
Given that Germany is Europe's largest economy, the DAX30 is a very popular index for international traders.
The companies represented by the DAX index include: Adidas, Allianz, BASF, Bayer, BMW, Comerzbank, Deutsche Bank, Deutsche Telekom , Fresenius, Henkel, Infineon, Linde, Lufthansa, MAN, Metro, RWE, SAP, Siemens, VW , and more.
The French stock index - CAC 40
The CAC 40 is the main stock index of the Paris market place and was established on June 15, 1988. The CAC 40 index is determined from the prices of the 40 companies with the largest market capitalizations listed on the Paris Stock Exchange.
Since December 1, 2003, the CAC 40 has adopted the floating market capitalization system to align with the way in which major global indices operate. This means that since that date, the number of securities available for purchase on the market for a company is taken into account in calculating the index.
Some of the companies listed on the CAC 40 index include: Air Liquide, Airbus, ArcelorMittal, AXA, BNP Paribas, Capgemini, Carrefour, Danone, L'Oréal, LVMH, Michelin, Renault, Sanofi , Total, and more.
The Eurozone stock index - STOXX 50
Finally, if you're interested in trading the Eurozone economy as a whole, there is an index you can use!
Euronext is the main stock exchange in the European area, and the Euronext stock index (the Euro Stoxx 50 index), includes 50 companies from the European area, based on their market capitalization.
Other European indices
While we've listed the most popular European stock indices above, there are a number of other European stock indexes. Here is a short list of them:
- Belgian stock index: The BEL20
- Greek stock index: Athex20 index
- Danish stock index is OMX Copenhagen 20 (or KFX)
- Dutch stock index: AEX25
- Finnish stock index: OMX Helsinki 25 (OMXH25)
- Irish stock index: ISEQ
- Italian stock index: FTSE MIB
- Luxembourg stock index: LuxX
- Norwegian stock index: OBX25
- Portuguese stock index: PSI 20
- Spanish stock index: Ibex35
- Swedish stock index: OMX Stockholm 30 (OMXS30)
- Swiss stock index: SMI20
Popular Asia-Pacific stock indices
While we often talk about the Paris Stock Exchange, the London Stock Exchange or the New York Stock Exchange, what about Asian stock exchanges?
Let's look at these in more detail now.
Asian and Australian stock indices often aren't as popular with UK and US traders due to the different time zones in which these indices operate. However, for those who are open to unusual trading hours, or who are trading around a day job, they can provide some interesting opportunities.
The Japanese stock index - Nikkei 225
The Nikkei Stock Exchange Index, also known as the Tokyo Stock Exchange Index, consists of 225 companies and is the most important stock exchange index on the Japanese stock exchange.
Companies represented by the index include Canon, Casio, FujiFilm, Fujitsu, Honda, Mazda, Nikon, Nissan, Panasonic, Sapporo, Subaru, Suzuki, Toyota, Yamaha and more.
Chinese stock indices - the SSE Composite Index, and the CSI 30
When looking at Chinese markets, we should mention the Chinese index: the SSE Composite Index. The SSE Composite Index is the most widely used stock index in China, reflecting the performance of the Shanghai stock exchange.
Another Chinese stock index is the CSI 300. The CSI 300 is the Shanghai stock market index of the country's 300 largest companies by market capitalization.
These stock indices are sometimes referred to together as the Beijing stock index, referring to the country's capital, although the country's stock exchange is located in Shanghai.
A third Chinese stock market index the FTSE China 50, features 50 companies chosen from the Shanghai Stock Exchange and the Shenzhen Stock Exchange.
The Hong Kong stock index - HSI50
Another popular Asian stock index is the Hong Kong HSI50 index. The Hong Kong stock market index comprises the country's 50 largest companies by market capitalization.
The Australian stock index - ASX 200
The S&P/ASX 200 represents Australia's 200 largest companies by market capitalization. These companies account for 82% of Australia's share market capitalization, meaning the ASX is one way you can trade on the state of the Australian market.
Companies listed in the ASX 200 include: ANZ Banking Group, Blackmores, Commonwealth Bank, Domino Pizza, National Australia Bank, Qantas Airways, Telstra Corporation, Virgin Money, Westpac Banking Corp, Woolworths, Xero and more.
If you'd like to trade US, European or Asia-Pacific stock indices, one of the first things you'll need to do is to download a trading platform. The good news is that you can download the world's most popular trading platform - MetaTrader 5 - absolutely free!
Trading Indices: Strategies and Time Frames
The best index trading strategy depends on a number of factors, including your risk tolerance, your availability, and how quickly you want to see a return on your investment. One of the main features of your strategy will be your trading time frame, which might range from scalping to swing trading.
Scalping is ultra short-term trading, where you aim to open and close trades within a few minutes. Because these trades are so short, the profit on each trade is usually quite small as well - just a few points per trade. This means traders need to trade very high volumes, or make a very large number of trades, in order to make a decent profit.
Index scalping can be done manually or with trading robots.
Day trading indices
Day trading means trading within a day. These trades tend to last for a few hours, rather than a few minutes, and day traders will open and close positions within a single day.
Swing trading stock indices
Swing trading is trading on a longer-term time frame - usually from a few days to a few weeks. Swing trading is often a good approach for new traders, because you do not need to monitor your positions at all times. When swing trading, you're less concerned with small daily price fluctuations, as you expect them to even out when you follow a longer-term trend.
Because stock indices follow economic cycles, they are well suited for swing trading. We can see this in the growth of the Dow Jones, Nasdaq and SP500 over the past decade, as all have grown alongside the US economy. With this in mind, if you like fundamental analysis rather than technical analysis, this time frame and instrument could be a match for you.
Best Platform for Index Trading
Now you understand the basics of index trading, you have a good overview of global stock indices and you have some insights into trading time frames. So which platform should you choose to trade?
A good option for trading stock indices online is MetaTrader 4 and MetaTrader 5. The MetaTrader platforms are the world's most popular trading platform, with extensive charting and trading functionality.
Plus, with Admirals, you can access a range of financial markets within the same platform, including CFDs on indices, Forex, commodities, cryptocurrencies and much more.
Admirals also offers the exclusive MetaTrader Supreme Edition plugin, which helps you supercharge your trading for free, with a range of extra features you can use within the MT platforms. Some of these features include
- Mini terminal
- Trade terminal
- Global opinion
- Indicator package
- Tick chart trader
- Trading simulator
- Mini charts
- Trading ideas and technical analysis from Trading Central
Other articles you may find interesting:
- Use MetaTrader Like a Pro With MT4 & MT5 Shortcuts
- How to Start Forex Trading Guide 2023
- Forex Fundamental Analysis: An Introduction
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