Indices: How They Are Traded

Indices: How They Are Traded

Index trading involves attempting to gauge whether the value of an index is likely to increase or decrease, instead of the trader actually buying any shares.

A trader can initiate a Spread Bet or CFD on an index just as they would on a stock, currency or commodity. To try and make a profit, a trader will ‘buy’ an index, aiming to ‘sell’ it at a later date for a larger amount than bought for. Traders also consider selling indices at the start of a trade, with the intention of buying them back for a smaller sum in the future.

In its most popular format, an index is a portfolio of shares representing a market or market sector. Each share that is listed on an index contributes towards the calculation of the index’s value. Because the value of an index is a weighted average of all the shares it is comprised of, its movement depends on the performance of its component companies.

Share values are very much driven by the law of supply and demand. When investors see a company performing well, for example, in anticipation of higher earnings from the firm, more investors will want to buy shares in that company. If more investors want to buy rather than sell a company’s shares, that company’s share price will increase. On the other hand, if more investors are interested in a selling than buying, the share price would drop.

This means that a rise in share price does not necessarily reflect a company having increased its profits, but more so that it is being perceived as high-performing by investors. So, if the FTSE 100 is ‘up’, more investors are buying the various stocks on the index than selling them and share prices have increased. If more shares of the component companies are being sold than bought, the index declines.

The Volatility of Indices

The Volatility of Indices

The constant movement of the different stocks that an index is made up of can make it a relatively volatile market to trade. However, it is rare for all the component shares to experience large shifts in the same direction at once – indices generally don’t move by more than around two points each day. However, this does not hold true in the case of stock market crashes or slumps. In the ‘Black Monday’ of 1987, the Dow Jones fell by more than 20% in one day. In a more recent example, the Shanghai Composite prolonged slump in mid-2015 saw the Index fall significantly – well over 2% - for days on end.