Whether it’s the Dow Jones, DAX, FTSE 100 or one of our sector-themed indices such as the Green Index, get exposure to global markets without relying on the performance of a single company. Learn more about indices, from what they are, how they’re calculated and what drives prices to different indices trading strategies and instruments available. Continue reading to find out how to invest indices via CFDs on Growth Edge Traders.

What are indices in trading?

Index trading is a popular way for traders to gain exposure to financial markets without having to invest in individual company stocks, bonds, commodities or other assets directly.

Those who are new to financial markets often start with index trading, meaning they trade an index-tracking fund or a basket of shares, instead of buying and selling individual company stocks. By tracking the performance of a large group of shares, a stock index aims to reflect the state of a broader market, for example, the stock market of a country or a specific sector. This means that indices tend to be diversified.

Every one of the world’s major financial markets has at least one stock index to represent it. For example, the S&P 500 (US500) is an index of the 500 largest companies in the US. As these benchmark indices often reflect the performance of the overall stock market, movement in the benchmark’s value indicates the health of the economy or industry sector it tracks. Another benchmark index, the Euronext 100 (N100) tracks the performance of the largest stocks on Europe’s Euronext exchange, comprising companies listed in the Netherlands, France, Belgium, Portugal and Luxembourg. Other major indices include the UK’s FTSE 100 (UK100), Germany’s DAX 40 (DE40), Hong Kong’s Hang Seng (HK50) and Japan’s Nikkei 225 (J225).

Equity indices provide benchmarks for fund managers to measure their actively-managed fund performance against. Fund providers also create passive index-linked funds, associated derivatives are also available for investors to buy and sell. Passive funds, also known as tracker funds, hold stocks in the same proportion as the index to match its performance. Active funds are managed by fund managers, who aim to outperform the index. Fund managers charge an annual fee as a percentage of the fund’s value. Exchange-traded funds (ETFs) are an increasingly popular way for investors to get started with stock indices trading. ETF fund managers, such as Vanguard, charge relatively lower fees, allowing investors to keep more of their returns. As they are traded on exchanges, the price of these funds fluctuates throughout the trading session, unlike a mutual fund for which the price is settled once daily. ETFs can be bought and sold quickly and easily through stock trading platforms. Dividends paid on the company stocks in an index-tracking fund can be distributed to investors, known as a distribution fund, or reinvested back into the fund, known as accumulation fund.

How are stock market indices calculated?

The first trading indices were calculated as simple averages. The share prices of all the constituents were totalled and divided by the number of companies. However, today some major indices such as the Nasdaq 100 (US100) and the Hang Seng are weighted averages. Stock indices are calculated in different ways based on the types of companies they track and the goals of the index. Some index calculations give more weight to stocks with higher prices, while others base the weighting on market capitalisation, and others weigh all constituent stocks equally. The two major formulas used to calculate the value of a weighted index are price weighted and market cap weighted.

Price weighted

In price-weighted indices, the stocks are weighted in proportion to their share price rather than the size of the company. This means that companies with the highest share prices have a stronger impact on the value of the index. Price-weighted indices are less common than those based on market cap. The Dow Jones Industrial Average (US30) in the US and Nikkei 225 are both price-weighted indices.

Market capitalisation-weighted

A market capitalisation weighted index uses the value of its constituent companies to rank them. Market cap is calculated by multiplying a company’s stock price by the number of outstanding shares. Companies with the largest market capitalisation will have the highest influence over the index’s value. The market cap of each company is calculated based on free float shares publicly available for trading. A company’s free float market cap is lower than its total market cap, as it excludes shares held by company insiders. The FTSE 100 and DAX 40 are examples of market-value-weighted indices.

Unweighted

An unweighted, or equal weight index gives the same weight to each of its constituent companies. This limits the influence that one stock can have on the overall performance of the index, reducing volatility while also dampening the effect of a sharp rally in a particular stock. The S&P 500 Equal Weight Index (EWI) is an equal-weight version of the S&P 500 that offers an alternative for traders looking into trading indices with more price stability.

How are indices compiled?

Indices are managed by committees, which set the criteria that company stocks must meet to be eligible for inclusion. These committees meet regularly to review the index rules and decide whether to add or remove companies. Some committees hold reviews quarterly, while others do so annually. Committees can remove stocks that no longer meet the eligibility criteria, while others allow them to remain, or give them time to return to compliance.

What moves the index price?

The factors shaping an index price would largely depend on what assets the index consists of. For example, stock market index prices fluctuate based on constituent companies’ share prices. For commodity indices, on the other hand, commodity prices are crucial drivers.

• Economic news
• Company financial results
• Company announcements
• Changes to index composition
• Currency movements
• Geopolitical events
• Investor sentiment
• Commodity prices