Indices are a collection of stocks and instruments used to track the growth or trajectory of an industry or sector. These whole-sector tools allow us to look at how a chunk of the market is performing to better understand investment opportunities along with market fluctuations.
The S&P 500 (USA), DAX 40 (Germany) and FTSE 100 (UK) are a collective of each country’s largest companies based on their market capitalization. As an index tracks a basket of publicly traded stocks, by following the index, traders can understand the broad movements of the market and plan out their investment strategy accordingly.
To better understand how indices are calculated, it is important to understand how they are constructed.
Each exchange requires their listed companies to maintain a high standard of accounting and public reporting. Companies such as Standard & Poors (S&P), Xetra, Financial Times Stock Exchange Group (FTSE), and others review these published reports to audit the health and growth of publicly traded companies.
Once compiled, these companies publish their findings, which global investors have relied on for decades. The S&P 500, Xetra’s DAX 40, and the FTSE 100 have reliably guided investors through both prosperous and challenging times, providing honest insight into some of the world’s largest companies.
Indices rise and fall on a daily basis. Calculated by grouping together similar companies, traders’ use these tools as whole market or sector indicators to better understand market movements.
For example, after an announcement by Netflix, you predict that it will have a positive effect on the tech industry as a whole. You can open a Buy position on Plus500’s US-Tech 100, hoping to profit on this index’s movement. If the index does indeed rise, you can close your position and profit from the difference between your purchase price and closing price. On the other hand, if the index falls and you close your position, you will incur a loss.
If you predict that there will be a negative effect on the index, you can open a Sell position. If the price does indeed drop, you can close your position and make a profit from the difference. If the value of the index rises and you close your position, you will incur a loss.
Trading on indices can be an effective way to diversify trader risk, as it provides wider exposure when compared to trading on an individual stock.
When trading on a stock, fluctuations in the stock price are based on a large number of factors such as performance, revenue, and confidence in their ability to produce exciting products. When trading an index, a handful of poorly performing constituent companies do not necessarily affect the index’s value one way or the other. If a handful of constituent companies report losses or poor performance, it is still possible for the index to rise, depending on their weight. At the same time, if some companies report gains, the index may fall if a higher weighted company reports losses.