Home Market What is a stock market index – complete guide and FAQ

What is a stock market index – complete guide and FAQ

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Nowadays, anyone can buy the stocks of almost any company they are interested in just a few seconds. What if you can buy the securities of a few dozen companies at one trade? Thus, you can lower the risks associated with a price drop of the shares in a single company.

That is what stock indexes were created for. By trading indices, you can invest in entire industries and clusters of companies united on any basis. In this article, I will take a closer look at  what is index in stock market, listed indices, how they work, and the features of trading stock indexes with LiteFinance, as well as the most profitable indices trading strategies! 

The article covers the following subjects:

What Is a Stock Index

A stock market index is an indicator of price changes for a chosen group of stocks or other assets. Differently put, an index indicates the average value of prices for a certain portfolio of stocks, united by some common feature.

Indices are calculated according to different formulas: by a simple arithmetic mean or by a weight component, that is, weighted arithmetic mean of stock prices. However, it makes no sense to learn all formulas or try to understand them thoroughly as the stock market index value is calculated automatically.

Index Examples

Almost any market offers an opportunity to invest in an index fund. Below, I will elaborate on stock indices with the highest market capitalization.

Dow Jones

The spread of trading in stock indices is largely due to the emergence of the Dow Jones Industrial Average index (DJIA). It  is one of the oldest, most well-known, and most frequently used indexes in the world, which includes the stocks of the 30 largest companies in the USA.

Initially, Dow Jones reflected the performance of the industrial component of the US stock markets. Now, with the development of the IT and the service sector in the US, the DJI30 has little in common with direct investment in the industry. Currently, it includes companies such as 3M, American Express, Amgen, Apple, Boeing, Caterpillar, etc.

The components of the price-weighted Dow Jones index are traded either on the New York Stock Exchange (NYSE) or on the Nasdaq stock exchange. Therefore, the best time to trade the DJIA is the working hours of these two stock exchanges, from 9:30 to 16:00 EST from Monday to Friday.

  

S&P 500

The Standard & Poor’s 500 Index (known commonly as the S&P 500) is market-cap weighted index that includes the shares of 500 top companies. The Index is calculated based on the average weighted market cap of the companies listed in the index. Therefore, every stock in the index is represented in proportion to its total market capitalization.

One of the features of the S&P 500 is its high cost. Therefore, only traders with high leverage or a significant deposit can buy contracts. The index is listed on the NYSE and the Chicago Stock Exchange, but you can trade the SP500 after these exchanges close. However, speculative liquidity of the S & P500, in this case, is noticeably reduced.

It is also possible to trade ETFs – a derivative instrument that completely repeats the movement of the original market-cap weighted index but has a lower price. 

  

NASDAQ

It is a broad-based index. In fact, there are three NASDAQ indexes:

  • NASDAQ: Composite is the most popular one, it includes more than 2500 companies.

  • NASDAQ 100 is a market-capitalization-weighted index that includes the securities of the 100 largest high-tech companies.

  • NASDAQ Biotechnology is the stock market index covering the largest  biotech and pharmaceutical companies.

The best time to trade Nasdaq (IXIC) securities is between 9:30 am and 4:00 pm (GMT-5). Among the benefits of investing in this stock market index, first of all, we should mention the weak dependence of the companies included in the NQ100 on common fundamental factors. Instead, NASDAQ quotes are heavily influenced by high-tech news.

  

FTSE

FTSE 100 Index is the most significant stock market index in the UK. It is a market-cap-weighted index that includes 100 top companies in the UK, traded on the London Stock Exchange.

The best time to trade the FTSE 100 is the working hours of the London Exchange, from 8:00 to 16.30. It is a universal index, and one could use a wide range of instruments to use it, stocks, options, ETFs, CFDs, futures, and so on. Investors can make trading decisions based on technical analysis, indicators, and fundamental analysis. 

  

FDAX

FDAX 40 (former DAX30) another European stock index, covering 40 top German companies, as well as the dividends they pay. Due to the diversification of assets, it features high liquidity, attracting a lot of investors. The best time to trade DAX is from Monday till Friday from 09:00 to 23:00 EET.

 

ASX200

S&P/ASX200 is the benchmark index for the financial markets of Australia. It is calculated based on the weighted method and covers the stocks of the 200 largest Australian companies. The ASX200, like other major indices, is highly liquid. The optimal trading time is limited by the work of the Australian Securities Exchange, 10:00-16:00 (GMT+10).

HK50

HK50 (Hong Kong 50) is the index traded on the Stock Exchange of Hong Kong. Most experts consider it the world’s most accurate stock indicator, which is calculated based on the market capitalization of the largest companies in Southeast Asia, operating in 12 different industries.

Traders are attracted by the high speculative value of the HK50. The best time to trade is 9:00 – 16:00 (GMT+4).

 

Japan225

Japan 225, more commonly known as the Nikkei 225 or just the Nikkei, is a price-weighted index covering the 225 largest Japanese companies, whose stocks are traded on the Tokyo Stock Exchange. Experienced traders note that the Nikkei 225 chart closely correlates with the DJIA in almost all timeframes. It often repeats the movements of the Dow Jones with a daily delay. The best time for trading is determined by the working hours of the Tokyo Stock Exchange – from 9:00 to 15:15 (GMT + 9).

 

How Is a Stock Index Calculated?

Even if companies have a common market, their stocks are traded on the same exchange, for example, Euronext NV, it is difficult to combine them into a stock market index. At least because each company issues a different number of stocks. This is true if we remove a conditionally passive index, based on the simplest formula for calculating an arithmetic mean.

However, modern stock indices traded on the NYSE, Nasdaq, and others use more complex formulas. According to the type of weighting, there are distinguished three types of the stock market index:

There could also be a more advanced smart beta index or other types of indexes, which use alternative index construction rules in the weight constituent, different from traditional market capitalization-based indices. The beta scoring formula uses non-price parameters, for example, volatility, profits, dividends, and cash flows.

Market cap weighted

A capitalization-weighted index, also known as a market cap weighted, is a stock market index, in which individual components of the index are included in amounts that correspond to their total market capitalization. For example, the French index CAC 40 includes 40 companies, however, the prices of these companies’ stocks are not equally important in the value of the index. The companies with a higher market cap will receive a higher weighting in the index. Correspondingly, in a cap weighted index, the performance of companies with midcap or small market cap will have less impact on the value of the overall index. 

Price weighted

In a price-weighted stock index, each company’s stock is weighted by its price per share, and the index is an average of the share prices of all the companies. Price-weighted indexes give greater weight to stocks with higher prices, so companies with more expensive stocks have a greater influence on the stock market index value.

Equal-weight

Equal weight contrasts with weighting by market capitalization, which is more commonly used by indexes and funds. Equal weight is a proportional measure that gives the same importance to each stock in a portfolio or a stock market index fund, regardless of a company’s size or stock prices.

How to trade indices

Stock indexes themselves are not trading assets. Therefore, other financial products, such as futures or options contracts, are used to trade indices. These are purely settlement instruments and do not include delivery rights, such as energy futures. Therefore, after the purchase of stock market index futures, there is no right for a share in the ownership of the companies included in the index.

Another way of index fund investing is to buy ETF shares. Such an index fund is a mutual fund, a public company that buys the securities of the stock market index and issues shares backed by these assets.

One can trade ETF securities through a broker, investing relatively small amounts of money. In fund investing or trading ETFs, a trader can use any trading strategy, from scalping to swing trading. 

Trading indices on mt4

Follow a few simple steps to trade the stock market index on MT4 or MT5 platforms: 

Step 1. Open an account.

First, you need to sign in to an account on the www.litefinance.com website. Click on the Registration button and follow the instruction. It will take a couple of minutes to open an account. 

Step 2. Top up your deposit.

When you have registered, log in with your name and click on the FINANCE tab on the left.

In the window that opens, in the “Deposits” section, select the payment system, enter the currency and deposit amount, and then click on the “Continue” button. The minimum deposit amount is 10 USD. LiteFinance supports bank transfers, electronic payment systems, as well as cryptocurrency transactions. Next, you need to confirm the payment and wait for the funds to be credited. It usually happens instantly.

Step 3. Download the terminal

Select the METATRADER tab and click on the DOWNLOAD TERMINAL button. After the terminal is downloaded, install the MT4 and connect it to your trading account. 

Step 4. Open the indices market

Launch the MetaTrader and connect a trading account to it. To do this, enter the trader’s login and password and select the appropriate server. After you open your trading account, all information about it comes to your email. In addition, you can view this information in the METATRADER section on the LiteFinance website.

Select the View tab in the top menu and choose Symbols.

There, you will see all available trading instruments. However, most of them are not active. To trade stock indexes, open the Major Indices tab and click on the symbols of the needed instruments. The symbol becomes yellow when the instrument is active. When you have enabled all the needed instruments, close the window by clicking on the Close button.

Now, you can see the indices in the Market Watch tab and you can open the trading chart of any instrument. 

Step 5. Trading

To open the chart of the needed instrument, right-click on its symbol in the Market Watch window and choose the Chart Window item from the context menu. In the same menu, there is New Order item. If you click on it, a window for placing an order with advanced settings will appear.

There are Buy and Sell buttons in the top left corner to open buy and sell trades instantly. Below, I write about some popular strategies to trade stock indexes.

Popular Indices Trading Strategies

Well, as you now have stock market indices explained, it is time to practice. All exchange instruments draw technical analysis patterns in the charts and are subject to fundamental factors. So, trading stock indexes is similar to trading other forex assets.

Next, I will describe some successful indices trading strategies to enter trades. It is important to consider the working hours of stock exchanges. Stock indexes are rather responsive to the news environment. One should not trade in half an hour after the exchange starts operating and half an hour before closing. It is also advisable to close all trading positions at the end of the day.

Technical patterns trading

This strategy works in any timeframe and trading style. Stock chart patterns trading means spotting price patterns in the chart, like Flag, Pennant, Head and Shoulders, and others. The most complete list of price chart patterns is in the article Most efficient Forex patterns: a complete guide. An entry signal is when the price breaks through such a pattern, and an exit signal is when the price reaches a key support or resistance level.

A Double Bottom pattern is marked with purple lines in the FDAX chart. When the pattern forms, that is, the price goes higher than the pattern top, one should enter a long trade. The entry-level is marked with the blue line in the chart. A stop loss is set a little lower than the most recent local low and a trailing stop is turned on.

The closest target of the bullish movement is the resistance zone 13900-14100 USD, it will hardly be broken out by the price. A take-profit is at the lower border of this zone. When the take profit is reached, the position will be automatically closed with a profit.

Support and Resistance trading

A trader should draw two horizontal levels at the end of each trading day. The support is plotted around the daily low, the resistance – around the high.

This is an intraday trading strategy. You enter a trade when the price breaks out one of the levels and a 15-minute or 30-minute candlestick closes beyond the level. A Take-Profit level is calculated according to the following formula:

The breakout price “+” (for a Buy trade) or “-” (for a Sell trade) the distance of ATR/3

A stop loss is set a little lower/higher than the breakout candlestick and is moved to a break-even level at the first opportunity.

Let us have a look at the above chart. On April 11, the price makes a low of 14096 and a high of 14058. The support and resistance levels are drawn along with these points, purple lines.

At 4:00 on April 12, a red candlestick closes below the support level. Therefore, at the opening of the next candlestick, we enter a short trade. The ATR is about 40 points at that time. Let us calculate the take-profit level:

40/3=13.3 points.

As the point is 10 ticks with the broker, the take-profit level is 

14058-13.3*10=13925.

It is marked with the green line in the chart. A stop loss is initially set a little higher than the red breakout candlestick. It is marked with a red line in the chart. When the price goes down, a stop loss is moved to breakeven. One can also turn on a trailing stop.

Swing trading

This is a very simple intraday indices trading strategy. It doesn’t require considering fundamental factors or numerous technical signals. 

A trade is entered based on a reversal signal sent by a technical indicator. For example, the MACD reversal signal is the crossing of the lines. A trade is exited when there are signs of trend exhaustion. In addition, the support/resistance levels can be used. The strategy means entering as many trades during a day as possible.

In the above chart, entry points are marked with blue circles. The trades are opened when the MACD lines cross. Green circles mark the exit points. At the exit points, there are signs that the trend is exhausting – the MACD histogram is moving flat or in the opposite direction.

Pros and Cons of Stock Indexes

Stock indexes, like any other trading instrument, have their advantages and drawbacks. In the table below, I summed up all the key pros and cons of indices trading you should take into account.

Pros

Cons 

Easy to acquire. You can buy futures for the largest world’s indexes through numerous forex brokers. You don’t need a large capital to start trading. 

Additional expenses. Brokers pay depositary services in the stock market, which widens the spreads. 

Diversification. If you invest in individual stocks of a particular company, you can lose because of some company problems. Trading indices eliminates such a risk. 

Trading hours are limited. You can trade only during the working hours of stock exchanges, where indices are traded. 

Liquidity. You can buy and sell the stock market index at almost any time. 

When you buy futures on an index, you do not claim the dividend yield of companies included in these indices and you are not a shareholder of the company, because you trade a CFD or ETF.

Relevance. The stock market is really popular. It means you will hardly ever face a drop in demand for ETFs, at least, in the near future.

 

Volatility. The trends in stock indexes are more predictable than the moves in prices of a single company’s stocks. 

 

Conclusion

Stock indices are not just indicators of the performance of big companies or industries. It is a trading instrument that you can trade just like stocks or currency pairs. To make profits from stock indices trading, you need to study the trading history, apply technical and fundamental analysis, monitor indicator signals, develop and test a profitable trading strategy.

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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