Stock indices are among the most quoted and least understood financial investment tools around.
Yes, we’ve all heard the radio news announcer declare that the Dow Jones or the NASDAQ is up fifty points, but what does that actually mean? And how can you take advantage of such moves as an investor? That’s what we’re here to find out in this blog post.
All trading involves risk. Only risk capital you’re prepared to lose. This is not investment advice. CFD trading.
What are stock indices?
Indices were originally invented as a way of measuring a stock market’s health. It would be difficult to measure the state of the entire market based on a single stock – while one stock is down, another may be up, and so no one stock can ever reflect the larger picture. But if you took a selection of stocks, especially if they were the stocks of the largest companies in a certain economy or business sector (e.g. automotive or banking), you could get a glimpse into where the market was headed as a whole.
This is where stock indices come in. An index is basically a number which reflects the accumulated changes of each stock within a certain group of stocks, which are selected to represent a portion of the overall market.
What kind of stock indices are there?
Each stock index is comprised of a varied number of stocks, which are chosen according to different criteria; each index has its own individual way of selecting the stocks that best represent a market or sector and calculating the stocks’ average price. Almost every major stock exchange in the world has at least one major stock index that investors follow as a measure of the health of stocks traded on that exchange. For example, the index representative of the London stock exchange is the FTSE100. In France, it is the CAC40, in Germany the DAX30, in Australia the AUS200, etc.
In the US, there are two major stock exchanges, the NYSE (New York Stock Exchange) and the NASDAQ, and there are three major indices that cover stocks traded on both of these exchanges. The DJ30 (Dow Jones 30) represents the 30 largest companies traded on both the NYSE and the NASDAQ exchanges; the S&P 500 (Standard & Poors 500) represents the 500 largest companies traded on the NYSE and the NASDAQ exchanges; and the NASDAQ100 represents the 100 largest non-financial companies traded on the NASDAQ exchange alone. Unlike the Dow and the S&P, the NASDAQ index includes companies incorporated outside the US.
How are stock indices calculated?
As we already mentioned, each index has its own unique calculation formula. Having said that, these formulas usually include the three following components: stock price, market capitalization and divider.
Clearly, the basis for calculating any index is the price of the stocks represented in the index. In the past, if an index had 30 stocks in it, one would simply add up the prices of all the stocks and divide them by 30, producing a simple average. Nowadays, indices are calculated as a weighted average based on market capitalization. Market capitalization is the total worth of the company’s public value, calculated as: The total number of outstanding shares X the share price. The larger the company’s market capitalization, the more its price impacts the index.
The final weighted average is then divided by the “divider”. This is a changing number, decided upon by the index committee, that is used to preserve the index’s historical continuity. It is because of the divider that the DJ30, for example, is currently ranging above 16000, even though none of its represented stocks’ prices come anywhere near that figure.
Why invest in stock indices?
Indices are a perfect way to invest in the overall movement of a certain stock market. If you think that an entire stock market is headed upwards or downwards, rather than investing in individual stocks in that market, you can invest in a representative sample of that market through an index. If you think that the market is heading down, you can open a short position on an index and speculate on a general downward trend in stock prices.
Finally, indices are leveraged products, which means that you have the flexibility to manage your risk as you see fit. The lower the leverage the lower your risk exposure to market fluctuations.
How can I invest in stock indices?
Traditionally, stock indices were invented as simple numerical measures, not investment instruments. However, pretty quickly, investors saw the value in speculating on index prices through CFDs (Contracts For Difference). Nowadays, you can invest in stock indices on eToro just like you invest in currencies or commodities.
Simply login to eToro, select your preferred stock index from the Trade Markets menu and click on the index you’d like. Choose “Buy” if you expect the stock market to go up, or “Sell” if you expect a drop in the stock market. Select your investment amount, leverage according to your risk appetite and Stop Loss and Take Profit points, and click ‘Open Trade’ to execute your trade. Your stock index position will then immediately appear in your portfolio.
Remember, if you don’t feel comfortable yet investing in stock indices on your own, you can always find an eToro investor with an indices-based portfolio to follow or copy. If you don’t have an eToro account yet, click here to sign up.
All trading involves risk. Only risk capital you’re prepared to lose. This is not investment advice. CFD trading.