Indices serve as barometers, providing a measure of the price performance of a specific group of shares from an exchange. An excellent example is the FTSE 100, which monitors the 100 largest companies on the London Stock Exchange (LSE).
Engaging in index trading presents a unique avenue for investors to gain exposure to an entire economy or sector through a single position.
Trading indices involve predicting the price movements of a collection of stocks without the necessity of owning the underlying assets. This is made possible through contracts for difference (CFDs), which enable traders to speculate on whether an index’s price will rise or fall.
How are Indices Calculated?
Understanding how stock market indices work is like getting the blueprint of the financial world. Most indices follow one of two methods to decide which companies matter more: the “market cap” way and the “price-weighted” way. Let’s break these down in simpler terms.
1. Market Capitalization-Weighted Indices:
Imagine the stock market as a big pie, and each company gets a slice based on its size. “Size” here means market cap, which is just the total value of all a company’s shares. Bigger companies get bigger slices. So, in a market cap-weighted index, like the S&P 500, if a giant company’s share prices go up a lot, the whole pie feels it.
Example: Think of Apple as the big player. If Apple’s shares go up, it’s like the giant slice of the pie getting even bigger, making a big impact on the whole pie (the index).
2. Price-Weighted Indices:
Now, picture a different way. Instead of size, we focus on the price of each company’s shares. This is the deal with the Dow Jones Industrial Average (DJIA). Here, it doesn’t matter how big a company is; what matters is how much each share costs. So, if a pricey stock goes up, it has a big say in the index.
Example: Consider Goldman Sachs as the expensive player. If its share price jumps, it’s like a big voice in the index, even if Goldman isn’t the biggest company overall.
What Should You Know?
- Diversification: Market cap-weighted indices give a mix of all kinds of companies. Price-weighted ones might make high-priced stocks sound louder, giving more weight to them.
- Big vs. Expensive Impact: In market cap-weighted indices, the big players talk more. In price-weighted ones, it’s about the expensive ones having a say.
- Handling Ups and Downs: Market cap-weighted indices handle ups and downs more steadily. Price-weighted ones might jump around more with expensive stocks.
- When Companies Change: If a company’s total value changes, you’ll notice in a market cap-weighted index. But in a price-weighted one, if an expensive stock changes, it might shake things up.