Trading indices explained
When people hear about trading, they usually think about individual assets like currency pairs, stocks,
commodities, and others. They think that traders buy and sell only those securities, however, there are other types of assets that can be traded or used for informational purposes.
One such asset type is called an index. As for the indices meaning, they are a financial instrument that combines individual assets and represents their average value. Big financial companies track the prices of these assets in order to enable interested people to get a general view of the economy.
Types of index trading explained
For example, stock indices are the most popular index types in this industry because they combine some of the biggest companies in the world. And because of that, many economists, traders, and other people find them useful for getting a better view of the economic condition in the country. If the companies listed in the index are successful and growing, the index value will be increasing as well. And this will indicate that the economy is doing good.
On the other hand, if the index value is decreasing, this means that the companies are unsuccessful and the economy is in crisis. These conclusions may not always be very accurate, but for the general picture, they are still useful.
As we mentioned above, stock indices are the most popular types of index in finances. However, there are other types as well, such as indices in Forex, bond indices, etc. The most popular Forex index is USDX (also known as DXY or DX), which is a measurement of the US dollar against six other international currencies: euro, Japanese yen, Pound sterling, Canadian dollar, Swedish krona, and Swiss franc.
What are the most popular stock indices?
Because of the importance of stock indices in the financial world, let’s continue the discussion with them. One of the best-known indices on this market is the Standard & Poor’s 500, also known as the S&P 500. It combines almost 3/4 of the total stocks traded on the New York Stock Exchange (NYSE), including the biggest companies in technology, health care, finances, and other industries. And if the overall price of those companies’ shares increases, the S&P 500 value increases too.
But the S&P 500 is not the only popular and influential index in finance. The equally important indices are:
- The Dow Jones Industrial Average
- Nasdaq 100
- The FTSE 100
- The Euro STOXX 500, etc.
What are indices in real-world trading?
Traders can use indices in two ways: they can either buy the individual assets and use indices to track their price movements more accurately, or they can use those indices as CFDs and actually trade using them. Let’s talk about both of those options.
Using indices as market indicators
So, what are indices in trading? According to the first option, indices can be used as market price indicators. Because they combine lots of individual assets, the price of an index actually becomes the general indicator of how the industry is working. Here is what it means:
If the price of an index is increasing, that means the individual asset prices are also rising, and the industry is working well. This information can be used for trading the individual assets; a trader can conclude that since the index value is going up, it may be worth buying a certain asset because its price may increase even more.
On the other hand, if the index price starts declining, a trader can take a note from it, speculating that even though their asset is still stable or increasing, its price may start declining because other assets are behaving that way.
Now, all those conclusions are speculations and cannot always work the same way. Sometimes, those predictions will become the reality, but sometimes they will not. It is important to keep this in mind when using indices as price indicators.
Using indices as trading CFDs
Another option, as we’ve discussed above, is to use indices as
CFDs (contracts for difference) and trade them. Many traders use a method of buying many assets - which is called portfolio diversification - as a form of reducing risks. And since indices combine individual assets, they can be considered as diversified portfolios that contain a basket of various stocks, currencies, or other assets.
But there is a difference between what are indexes as CFDs and what are diversified portfolios: the second option requires them to own the assets, while the first one doesn’t. For example, a trader can open a long position (buy) on the FTSE 100 index without buying any assets, which basically means this: a trader speculates that the value of this index, as well as its assets, is going to increase in the future.
If the value actually increases, a trader will get a payout from this CFD trade. The amount of payout depends on the difference between the initial price, when a trader placed the long position, and the final price, when a trader placed the short position (sell). But if the FTSE 100 value goes down, a trader will have to pay the price difference.
One of the reasons why traders tend to choose indices for trading is that they offer a much larger exposure to the market. What this means is that the index traders usually open positions without conducting detailed research on the market. That’s because the general direction of the index prices can be a good indicator of how the industry is doing. Besides, the indices are less volatile because the individual assets cannot have a big influence on their value.