Because of the volatility, tight spreads, and clear chart patterns that result from indices markets, traders who trade in the indices market have a wide range of trading opportunities. However, just like other financial assets in the financial markets, trading in indices markets requires skill and expertise.
In this article, we are going to explore all the skills that are necessary for start trading, including how the indices prices are calculated and what moves indices markets.
What are Market Indices?
Also referred to as stock market indices or stock indices, market indices refer to a segment of the stocks or share prices of a list of companies in a particular financial market.
Investors use market indices to measure and track the collective performance of a particular market and eventually use that information to make investment decisions.
Indices are calculated at a global, regional, or national level, with some indices focusing on only one section of the market. For example, the Dow Jones Industrial Average(DJIA) index, named after Charles Dow, tracks the stocks of the top 30 companies in the United States (national index).
On the other hand, NASDAQ only tracks stocks in the technology sector. If an investor owns a tech company or is interested in technology, they might prefer to invest in NASDAQ rather than in DJIA.
While there are over 5,000 indices in the market, there are only three major stock indices in the US. They include the S&P 500, Dow Jones Industrial Average, and NASDAQ Composite Index.
How are Stock Indices Calculated?
Because the value of the indices heavily depends on the individual stocks and prices of the underlying holdings, the indices’ values keep changing with the movement of stocks and prices. The change in these values is calculated either on a daily basis when the market closes or in real-time. The result of these calculations is what determines the index’s performance and the respective market’s performance.
Here are three ways in which Stock Indices values can be calculated:
- The Market Capitalization (Market Cap) Weighted Average Method
The stock index value is calculated by taking into account the market shares or stocks of the individual companies that are in the index. The stocks are then weighted using the Market Cap method, where the total number of one company’s shares is multiplied by the current price of one single share.
Using Mathematical tools, the value of one company in the index is calculated by dividing the Market Cap of one individual company by the Overall Market Cap of all the stocks in the index. For example, if a company’s Market Cap is $8 million, and the Overall Market Cap is $200 million, then the company’s value will be 0.04% of the index.
In this method, companies that have the largest market cap in the index have the biggest effect on the index movement, while those that have a small market cap have the least effect.
An example of a Market Cap Weighted Average index is S&P 500.
- The Price Weighted Method
Unlike the Market Cap Weighted Average Method where the market cap of the individual company’s was used to calculate the index value, the Price Weighted Method gives priority to the illustrative prices of the individual shares of stock of companies in the index.
The index value is calculated using a simple equation that adds the prices of every single stock in the index and then divides the sum by the overall number of all the companies that are in the index.
In this method, companies that have the highest stock prices have the biggest effect on the index movement, even if the said companies have a low market cap.
An example of a Price Weighted Index is the DJIA index.
- The Equal Weighted Method
Unlike the Market Cap Weighted Average method which gives weight to the market cap of the individual companies and the Price Weighted Average which gives weight to the stock prices, The Equal Weighted Method gives equal weight to all the stocks in the index.
The value of the index is calculated by adding the returns of each stock in the index and then dividing the sum by the total amount of stocks.
Examples of Equal Weighted Indices are The Index Funds S&P 500 Equal Weight ETF and Invesco Russell 1000 Equal Weight ETF.
What Moves Indices Markets
Finding out what forces are behind the change in stock index prices is essential, not only because it will allow investors to understand more about the price movements in indices, but also because investors can use these factors to their advantage and make wiser investment decisions.
Below are four factors that move indices markets:
- The Individual Companies in the Index
One of the major factors that move indices markets are the individual companies that make up the index. Because these companies are the backbone of the market indices, every decision made by the companies’ internal directors that affect the company’s finances eventually affects the market indices.
Some of the decisions that can affect a company’s finance are:
- Whether to go for stock splits.
- How to keep accounting records
- Whether to change their main supplier
- Whether to invest in a new start-up or a business.
However, investors should note that because some companies have more weight in the index than others, they will affect the index movement more than the rest. More focus should therefore be given to these companies when analyzing the index markets.
- Economical Data
Because the economy is one of the major factors that affect the stock market, which later affects the indices markets, investors often check the economic data of the market before making an investment decision. Some of the economic data that investors look at include:
- Rates of Unemployment
- The total value of business investments
- Interest Rate decisions
- Positive Earnings Reports of the companies in the index
- Political Events and News
Negative political events like international trade disputes, political instability, and failed trade agreements between countries can adversely affect the larger market events and consequently affect the indices markets.
On the other hand, positive political events like de-regulation and free trade will have a good effect on the indices markets.
News about global, national, or events in the market that is digestible by thousands of investors can also affect the movement in the indices markets. For example, market or company news that informs investors of Apple Company is pulling its company shares out of the S&P 500 index might lead to some of the investors pulling out of the index too.
In the same way, global news that informs investors that one of the major economic sectors of the index has been affected by natural disasters might influence the investors’ investment decisions.
- Market Sentiment
This refers to the feelings and mindset the market participants have about the market and how it moves. While mostly subjective, the market sentiment of the investors can greatly affect the indices markets as it affects what indices the investors invest in.
Why are Traders Interested in Stock Indices?
As mentioned at the beginning, market indices can be very beneficial to traders in the stock markets. Here are three advantages of stock indices and reasons why traders are interested in trading them:
- They have a lot of trading opportunities – because the values of stock indices keep rising and falling in the market, they produce high market volatility that creates plenty of trading opportunities for traders and investors alike.
- They can be traded either up or down – unlike other assets, traders can trade indices in both directions – up or down. This provides the traders with more chances to gain from the trade.
- They are affordable – traders can start trading with a small, affordable amount of money if they are trading with exclusive sector-specific indices CFDs that let them use a ‘leverage’. The ‘leverage’ allows the trader to manage and trade with a larger sum of money than the one in their account.
The Bottom Line
Trading indices is a good investment, whether you are a beginner trader or an advanced one. It will not only yield more profits because of the many trading opportunities, but it will also give you the diverse skills and expertise needed in the market.
To get the best experience in trading indices markets, you should register at a brokerage company like Focus Markets or Tixee that will match you to buyers and sellers who offer the best process.
Click here to register an account with Tixee, and start your indices market trading!
Frequently Asked Questions
- What are some of the trading indices’ strategies?
Some of the major trading strategies used in indices markets are Bullish Percent Index, Consolidation/retracement breakout, and Deeper Retracement Entry Strategy.
- What is a Margin Call and When Do I Receive One?
A Margin Call refers to a situation where the amount in an investor’s margin account is below the broker’s required amount. When this situation occurs, the broker will send a margin call to the investor demanding that they deposit more money in their account.
- What is Margin of Safety and How Can I Calculate it?
The Margin of Safety is the amount that results from subtracting the expected profitability from the break-even point. It is calculated by subtracting the break-even point from the current sales and then dividing the resulting answer by the current sales.
- What is Excessive Volatility?
It is a situation when the prices of the assets move up and down more than the predicted value.
- What is Product Offering?
These are features in a specific platform that help a company deliver a value proposition to a client.
- What are Market Correlations
A measure that determines how certain asset classes or broad markets move in relation to other asset classes or broad markets.
- What is a Non-tradable Share
A non-tradable share refers to shares that cannot be traded during a specific period. If a company has a non-tradeable 15% share, it means that they are not allowed to trade 15% of their shares.
Disclaimer: This article is not investment advice or an investment recommendation and should not be considered as such. The information above is not an invitation to trade and it does not guarantee or predict future performance. The investor is solely responsible for the risk of their decisions. The analysis and commentary presented do not include any consideration of your personal investment objectives, financial circumstances or needs.
Risk Warning: Our products are traded on margin and carry a high level of risk and it is possible to lose all your capital. These products may not be suitable for everyone and you should ensure that you understand the risks involved.