In addition to being able to trade stocks in a company, a stock market one is also able to trade an index. Trading indices are done by buying and selling, the same way as is done with individual shares.
An index is made up of a group of companies. Their price is based on the average share price of the whole group.
Indices can be bought and sold in the same way that one trades individual shares. Indices are used to form a view of the economy, market sentiment or a business sector as a whole.
Take, for example, the price of US Index, S&P500, is based on 500 different companies’ share price.
There are many different indices. Each of them uses different formulas which determine the price of the index.
In various sectors, there are different specialized indices. An example is the NASDAQ Biotechnology Index. This index only includes biotechnology research companies.
Rice-weighted and market-weighted indices
Each of the two main types of index uses a different formula which determines the price of the index.
The market value or capitalization weighted indices are based on the weighting that a company has in the index on the total market value of the company.
Essentially, the larger the company, the bigger influence that they will have on the index as a whole. The most common type is the market value-weighted indices. One example of this is the FTSE100.
Price-weighted indices base a company’s weighting in the index on the share price of the company.
Companies that have large market capitalizations are the ones who have the biggest influence on the market-weighted indices. The companies that have high share prices are the ones that have the greatest impact on the indices that are price-weighted.
For companies that have a high share price, any changes in the share price have more ability to move the overall index than the changes that occur in a company that has low share prices. One example is the Dow Jones Industrial Average that is a price-weighted index.
Using indices to trade a region
Indices are more likely to be based on a region. Each index can be an indicator of the health of a specific economy.
The reason for this is that the price of an index drops when the company’s shares listed on it fall, which indicates that something may be wrong with either the overall economy or parts of it.
Take the FTSE100 as an example. It is often a forerunner of the UK economy.
Therefore, if you believed that the outlook for the UK economy was negative, you would be able to short sell the FTSE100 index with the expectation that UK companies would do badly, which could drag down the index price.
The German DAX30 and the French CAC40 are other popular regional indices.
Gauging the market sentiment by using indices
The market sentiment is not always rational. It does not inevitably track the economy’s expansions and contractions. Instead, it reflects the appetite for risk of the investors.
In addition to reflecting an economy’s overall health, indices can give an idea of the prevailing sentiment of the market, which helps you to weigh up if the other investors are either bullish or bearish.
The market sentiment is not always rational, and it does not automatically move in line with the economy. There is a relationship between the two. The intention for this has more to do with the appetite of the investor for owning risky assets, like shares for example, and they can periodically increase even when the economy is not performing well.
For example, if you have been following an FTSE-listed company and you based your analysis of its prospects you are interested in investing in it. However, the FTSE index then begins to drop, which may suggest that now may not be the opportune time to purchase those shares.
The reason for this is that the share price of the individual company may be pulled down by negative market sentiment instead of any significant weakness in that company. You may want to wait until the index overall is increasing, which will allow you to ride an uptake in sentiment.
Using indices to trade sectors
Many other indices focus on a particular industry or sector.
With these indices, you can form a view about whether a particular industry has good or bad prospects and then you can trade off on that basis.
For instance, if the new regulations in the US put pressure on the ability of the banks to turn a profit, you may sell the KBW Bank Index. The KBW Bank Index consists of the stocks of banking companies around the US.
The focus of trading sector indices is on defensive or cyclical industries that let you have a perspective on the state of the economy as a whole.
On the other hand, if you considered that if the Chinese economic growth bounces back, it may push up the prices of metals and it improves the mining companies’ prospects. You will then be able to purchase the FTSE 350 Mining Index of the large, FTSE-listed miners.
Even though a comprehensive understanding of a particular industry will help you, it is also possible for you to trade sector indices based on the complete state of the economy.
Particular business sectors are thought of as defensive, due to the demand for their products that stay stable even during times of recession. Types of defensive sectors are the pharmaceutical industry, food and utility producers.
Other sectors are considered periodic or cyclical. These sectors perform better during times of economic growth, and they can suffer during a downturn. The construction industry is one example of cyclical sectors.
You can decide to purchase or sell specific sector indices based on how the economy as a whole is functioning and what its prospects seem to be. In a downturn, one may sell cyclical sectors and to purchase defensive sectors. In times of economic growth, you can buy cyclical sectors.
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