What is a stock market index?
A stock market index is a index that follows a section of the stock market. These indices derive their values primarily from stock prices. Investors often use these indices to describe, measure and compare the aggregate performances of a group of selected stocks.
What is index investing?
Whether you like it or not everyone speculates on indices. Long term investments like pensions track them, or short term financial spread betting or CFD traders speculation on them. Below are some of the most popular stock indices for trading around the world.
Major indices for index trading
- Dow Jones Industrials Average (US 30)
- Standard & Poor’s 500 (S&P 500)
- Nasdaq (Composite and Nasdaq 100)
- Dow Jones Industrials (DJIA)
- UK FTSE 100 (FTSE 100)
- CAC 40 (France 40)
- DAX (Germany 30)
- Euro Stoxx 50 (Euro 50)
- Japan 225 (Nikkei 225)
- Hong Kong (Hang Seng Index)
Best indices for trading & investing
The rest of this guide helps you to understand these indices, what they are and how to trade them.
US S&P 500
Top of our list is the US Standard & Poor’s 500 Index (known as S&P 500). It is based on the market cap of the largest 500 companies listed on the NYSE or the NASDAQ. Because of its diversity, this index is one of the most traded stock indices. Its movements are widely followed. Investors reckon that S&P 500 is one of the best indicators for the US economy.
As such, S&P 500 can set the trend for many other indices around the world. You may not trade it, but you must understand it.
The Nasdaq is a growth-oriented stock market made up of younger companies wishing to list on a recognised exchange. It host many tech behemoths such as Facebook, Amazon and Google.
There are two popular indices created out of Nasdaq stocks: Nasdaq Composite and Nasdaq 100. The latter is slightly more volatile because it has less components. But volatility is seen as a positive thing because it presents more opportunities.
From the Nasdaq 100 Index, there is this exchange-traded fund called QQQ (cube). This ETF can be more popular than the underlying index at times.
US Dow Jones Industrial
The Dow Jones Industrial Average is one of the oldest indices around (1896). There are 30 constituents, primarily made up of industrial companies – which used to be a major portion of the US economy. The Dow was the key barometer of the US stock market in the first half of the 20th century. Its importance was overtaken by the S&P 500 after WW2 due to the narrowness of its components (only 30 stocks). But it is still an important index to follow because of its history. Many use Dow to reference the performance of the US stock market over a century.
UK FTSE 100
The Financial Times Stock Exchange 100 Index (abbreviated FTSE 100) tracks the top 100 companies listed on the London Stock Exchange. The index is market cap weighted, hence it is composed of many large established names like Unilever, BP and HSBC. The FTSE 100 is the most popular equity index in the UK due to its representativeness and liquidity.
The Deutscher Aktienindex or DAX, is a German stock market index. It derives its value from 30 major stocks on the Frankfurt Stock Exchange and is seen as a broad indicator of the German economy. Because of its small number of components, DAX can be more volatile compared to the FTSE 100 or the S&P 500 index. The Dax is a relatively young index. It started on 1987.
France CAC 40
The CAC (Cotation Assistée en Continu) 40 Index is a benchmark index of the French stock market. It has about 40 components, with famous names like LVMH and AXA. The international nature of its component stocks means that a lot of the index earnings are from outside France, hence its popularity with international investors. As an aside, Forbes calculated that LVMH’s owner Bernard Arnault is the second richest man in the world with a net worth exceeding $100 billion.
Japan Nikkei 225
Turning to Asia, one of the most active stock markets there is found in Japan. The most famous Japanese stock market index is known as the ‘Nikkei‘. This index is made up of the top 225 stocks (by market cap) listed on the Tokyo Stock Exchange. The index originated after WW2 and has a eventful trading history throughout Japan’s boom-bust cycle. It peaked in 1989 at 38,000 and traded as low as 7,000 in 2009.
Hong Kong (Hang Seng)
Outside Japan, perhaps the most well-known stock index is Hong Kong’s Hang Seng Index (HSI). The index has about 50 components, with a large number of china-related firms such as ICBC and BOC.
The index was extremely volatile in its earlier years. These days, the market still experienced bouts of manic buying (2007) and panic selloffs. A lot of investors like to invest in this index as a proxy for the China economy.
What moves index prices?
Knowing these indices is only the first step towards profitable trading. Calculations aside, the most important things to know about these stock indices are
- Index Constituents. What companies are the largest? What sectors are they in? The general rule of thumb is this: The bigger the company, the more influence it will have on the index, especially if the index has less than 50 components.
- Index Data. Company earnings, dividends, and floats. How much are the index components earning? And the valuation of the market? A highly-valued stock market may have trading dynamics different to that of a lowly-valued one.
- Index historical movements. Known what had happened in the past. In Japan, for example, earthquakes (’95) and tsunamis can have large – but temporarily – impact on the stock market. In the US, prices can collapse 20% in a day (’87). These are unpredictable factors. In Hong Kong, sometimes policy in China have huge impact on its markets.
- Macro Factors – such as tariffs, interest rates, unemployment, inflation can all impact the stock markets one way or another.
Index trading tips
Stock market indices can be a great place to learn how to trade. Many professionals just day-trade equity indices. You can learn to do this too. Here are six tips:
- Select equity indices are are relatively liquid. This give you tighter spreads.
- Stay ahead. Before trading the index, find out all you can about the market, such as earnings calendar and economic releases. Keep an eye on key data like GDP or unemployment/inflation.
- Keep focus on a few indices before branching out. Know the index inside out. Start with one direction first (buy).
- Choose appropriate trading instruments. For indices, you can choose futures, spot rates, or ETFs – depending on your appetite.
- Study past patterns. Be prepared for historical patterns because they can repeat. Know where the market is in terms of bull or bear trends.
- Create trading strategies from your market insights and follow them. Have a list of low-risk ideas.
Here’s where you can find even more on how to trade indices.
How do you trade indices?
If you want to speculate on indices, here are the most popular ways:
- Spread betting: place bets on a £ per point basis as to whether you think the price will move up or down. There is no capital gains tax on profits as trades are structured as bets. Compare spread betting brokers here.
- CFDs (Contracts for Difference): you speculate on the opening and closing price of your chosen index. Compare CFD Brokers here
How do you invest in indices?
You can either invest in indices through ETFs, index funds, robo-advisors or buying individual shares
- ETFs (Exchange Traded Funds): you can buy shares traded on the stock market that mirror the movement of an index. Compare stock brokers here.
- Index Funds are funds that either actively or passively track the performance of an underslying index – read our guide to index funds
- Robo-advisors simplify investing and break down markets into sectors, many of which are based on indices – read our guide to robo-advisors
- Buying shares that constitute an index will give you more flexibility if you want to exclude certain companies such as non-ESH firms.