What are indices and how do you trade them?

Equal-weighted: constructed by putting the same amount of capital into each stock, so they have equal weight within the portfolio.

Market capitalisation-weighted: made up of a set number of companies that have the highest market value. These tend to have a higher impact on the overall value of the index.

Price-weighted: give the most weight to stocks that are priced the highest. Stocks that are priced the lowest will have the smallest effect on the index.

It’s more of a low-cost method. When trading index CFDs, there are no minimum commission charges to pay, unlike when you trade on multiple stocks at once (other fees may apply).

They might pose a lower risk than individual stocks. As the risk is spread out across a number of assets, an index is unlikely to go to zero or go bankrupt, like an individual stock could.

Longer-term investors aim to diversify their portfolio​, since a wide range of stocks or other assets can be purchased with a single transaction. They are also popular for day trading, since indices are often discussed regularly in the news and have price movements throughout the day that day traders attempt to capitalise on.

When an index is rising, it is said to be in a bull market​. During such times, opening a long (buy) position allows traders to potentially profit from the rise without having to buy, trade or research individual stocks. Similarly, when one falls 20% or more, it’s said to be in a bear market and traders can potentially attempt to profit by shorting in a downward trending market if they think the market will fall down further.

S&P 500 includes 500 of the largest US companies by market cap, including Apple, Microsoft, and Amazon.

Dow Jones Industrial Average (or Dow 30) includes 30 blue-chip US companies, such as American Express, 3M, and Walmart.

NASDAQ 100 tracks 100 of the largest US technology stocks, with major holdings including Advanced Micro Devices, Adobe, and Alphabet.

FTSE 100 tracks 100 of the UK’s biggest companies, including AstraZeneca, Unilever, and Diageo.

Russell 2000 tracks 2,000 US small-cap companies, including Plug Power, Penn Gaming, and GameStop.

CAC 40 tracks 40 of the largest companies in France, including L’Oreal, Total, and Sanofi.

Nikkei 225 tracks 225 of the largest companies in Japan, including Mitsubishi, Kobe Steel, and Nippon Yusen.

DAX 30 features 30 of the largest German companies, such as Linde, SAP, and Siemens.

Hang Seng is composed of the largest stocks in Hong Kong, including Industrial and Commercial Bank of China, Xiaomi Corporation, and CNOOC Limited.

EURO STOXX 50/600 is composed of the largest companies in the Eurozone, including ASML, Linde, and Sanofi.

MSCI World holds stocks from multiple countries around the world, with its largest holdings tending to be US stocks.

The CBOE Volatility Index or VIX calculates the 30-day expected volatility in the US stock market.

NIFTY 50 represents the 50 largest stocks in India, including Reliance Industries, Tata Consultancy Services, and HDFC Bank.

S&P/TSX 60 is a benchmark for Canada, featuring 60 stocks like Shopify, Royal Bank of Canada, and Toronto-Dominion Bank.

KOSPI tracks 900 Korean stocks such as Samsung Electronics, Naver, and Hyundai Motor Company.

The number of advancing stocks versus the number of declining stocks (also known as the A/D line).

The number of stocks making new highs or new lows.

The number of stocks above or below a 50 or 200 day moving average.

The Arms Index [TRIN], which compares the AD ratio to AD volume.

The TICK index, which measures the minimum upward or downward price movement.

Politics and geopolitics can create stability and confidence, or instability and lack of confidence in the markets. When investors are confident, they tend to be more willing to buy stocks, which helps to push indices higher. When investors aren’t confident or don’t trust the stability of a political situation, they tend to save their money, which leads to stock prices to decline or be flat.

Monetary policy is used to control the amount of money in circulation. When central banks increase the amount of money in circulation, more of that money finds its way into the stock market, which helps to elevate stock prices. When central banks decrease money supply, this has a dampening effect on indices since there are fewer dollars in the economy for buying stocks or for businesses to spend on the pursuit of growth.

Fiscal policy, including tax cuts and spending, affects consumers, investors, and companies. Corporate tax cuts mean more profit for the company. That means better earnings and typically higher stock prices. The same concept applies to tax cuts for consumers, which gives people more money to invest in the stock market. Tax hikes tend to have the opposite effect by hurting corporate profits and leaving consumers with less cash.

Economic performance and indicators can tell investors how the economy is doing. Data on inflation and employment shows whether there is likely to be more or less money flowing into stocks. A strong labour market is typically good for stocks, while increasing unemployment is not. Lower inflation is usually better for stocks, while higher inflation tends to dampen an index’s performance.

Financial shocks and unforeseen negative events (sometimes referred to as black swan events) can lead to a stock market crash, such as unexpected incidents like a pandemic or a dramatic decline in another asset class that rattles investor confidence. It could be the failure of a major bank or corporation that affects many people and investors, or it could be a drastic change in tax law or government policy.

Investor sentiment is how investors feel toward stocks. As a group, are investors more likely to buy or sell? This is what pushes prices up and down. Sentiment is determined by all the other factors mentioned above. When sentiment gets extremely high, or euphoric, that is potentially a sign of a stock market bubble​.

Constituent performance is what directly affects the performance of stock indices, as this is what gives them their value. If the vast majority of stocks inside are falling, it should fall, and if the stocks inside are rising, it should rise.

Indices trading is considered by many to be a lower-risk strategy, as you are spreading your risk across an entire segment or sector, as opposed to a single stock. However, there are still some risks involved, such as the use of leverage, which can amplify losses and cause traders to lose their entire deposit if a trade is unsuccessful. However, please note that Retail clients benefit from a negative balance protection.

You are trading a derivative instead of a physical asset. Here, a derivative is an instrument that obtains its value from the price of an underlying asset, such as an individual stock or stock index. The risk is that the movement of just one stock or security could have a major impact on the overall value.

It’s therefore important to do some research prior to trading indices. It’s a good idea to make use of risk-management tools​ to protect your positions against sudden market moves. These include stop-loss orders such as guaranteed stop-losses. A stop-loss order will close a losing trade once price passes a trigger value pre-decided by the investor. These are very effective in the event of sharp price action.