Stock indices trading

Stock indices are one of the best instruments for trading on financial markets and the best way to diversify risks.

Stock index is an indicator of the state and dynamics of the securities market, which is calculated on the basis of the most liquid stock prices. Indices of various countries reflect the state of the most developed sectors and are indicators of national economies.

The formation of a stock index

In 1884 Charles Dow, the founder of the financial journal “The Wall Street Journal”, offered investors a kind of indicator of the overall market state, and not a specific stock. That was the first stock index called the Dow Jones Transportation Average.

The index was calculated on the basis of stock prices of 11 largest transportation companies in the US. Currently, the oldest of the existing indices is formed on the basis of stock prices of 20 transportation corporations.

The Dow Jones Industrial Average appeared in 1896. The index was equal to the arithmetic average of stock prices of 12 industrial companies in the US, which was nearly $70. Now it includes 30 largest companies in the US – approximately $180000.

The calculation of a stock index

The calculation of stock indices is made according to two main methods:

• Price weighted – at the closing moment of trades quotations of all stocks included in the index are added up and divided by a so-called divisor, the value of which changes when adding or excluding stocks of various companies. Dow Jones indices are calculated according to this method, which is considered to be their main disadvantage, because they do not take into account capitalization of companies included in the index.
• Capitalization weighted – the weight of each company included in the index is proportionate to its market capitalization. In other words, the larger the company, the stronger its impact on the index. The most popular index calculated through this method is S&P 500 (includes the 500 largest US companies by market capitalization), which is the barometer of the US economy.

The peculiarities of trading stock indices

The changes in index over time allows not only to analyze the overall state and direction of the market, but also to make money on trends. It is impossible to trade the index itself. Thus, transactions on direct purchase/sale are made through standardized futures. By purchasing or selling index futures, parties bet on change in underlying indictor. In other words, by opening a long or a short position on this futures, a trader conditionally buys or sells shares of companies included in the index.

Stock indices trading is also carried out through stock index CFDs, the price of which is determined by the values of relevant indexes or futures. The main advantage of trading CFDs on indices is the opportunity to trade with fractional lots and invest a small amount of money using leverage.