What are indices and how do you trade them

May 26, 2023

Stock indices are one of the most important elements of the global financial system. They represent the overall performance and trends within a specific country’s economy, and can also give a strong indication as to the state of the global economy as well. 

If you’ve ever wondered how indices trading works, what these indices represent in particular or how to understand what moves their price, read on to discover more in our in-depth guide.

What are indices? 

Indices are numbers which represent the top performing shares from a particular stock exchange. It’s a financial instrument which essentially gives a snapshot of an exchange’s major players, averaging out individual stock movements and distilling a huge amount of financial activity into just one figure.

Some of the largest indices in the world are:

• Dow Jones (in the US)
• Nasdaq (US)
• S&P 500 (US)
• DAX (in Germany)
• CAC (in France)
• FTSE (in the UK)
• Hang Seng (in Hong Kong)
• Nikkei (in Japan), and;
• ASX (in Australia) 

Indices can be calculated in two different ways; some take the performance of their  largest companies into account, a method known as a market capitalisation-weighted average. This is the case for the S&P 500, the FTSE and the ASX; the stock movement of companies worth the most on these exchanges have more sway over the index as a whole. Most stock indices use this method, however some are calculated using a price-weighted average. Both the Dow Jones and the Nikkei use this method, where shares that command higher prices also command more influence. 

Because indices represent the bundled overall stock value of the best performing company stocks or highest value stocks on a given exchange, rather than just the performance of one particular share, they can be more volatile than a single company’s stock. This volatility provides traders with both more opportunity, but also an increased risk. 

What is index trading?

Because an index is simply a number representing the performance of a group of shares on a particular exchange, you can’t buy and sell (i.e. trade) them directly. Instead, you need to choose to trade a product which mirrors their performance. 

Index trading therefore is trading products that do this, which include: 

• Index funds
• Exchange traded funds (ETFs)
• Futures
• Options, and;
• Contracts for differences (CFDs)
  

All of these products track the price of the underlying index, but not all require you taking ownership of that underlying asset directly. Instead, as a trader, you’ll speculate on whether you think the price of indices will rise or fall in any given period, and open or close positions accordingly. 

What moves the price of indices? 

There are a number of factors which can lead an index to rise or fall in price. In order to learn how to trade indices, you’ll need to be aware of and monitor these factors. 

• General economic news — Because price indices summarise the performance of multiple companies’ stocks, they are often seen as an indicator of an economy more generally. Likewise, economic news will affect their performance.
  
  Announcements by major banks, changes to investor sentiment, economic events, trade agreements, changes to employment figures and more can all cause a price index to rise or fall.
  
• Global news — Even within local price indexes, multinational corporations will be affected by global news events. Unexpected events like pandemics or natural disasters will create movement within an index, as can increased commodities prices, supply chain disruptions, global economic turmoil and conflicts.
  
• Company financial results — The performance of individual companies within an index will have a knock-on effect within the index as a whole. This is particularly true if the company is more highly valued or if its stock price is trading at a higher amount. In these cases, posting a major profit or loss will also have serious ramifications for the index price.
   
• Company announcements — Company announcements have big potential consequences for the future of that corporation. From leadership changes to mergers, updates to manufacturing or employment practices and restructures, the internal workings of individual companies will have broader implications for their stock price and therefore the index price.
  
• Index composition changes — Which companies make up an index will obviously make a difference to its overall price. The addition or removal of a company from an index will require traders to re-examine their positions.
  
• Commodity price fluctuations — Some indexes are made up of both company and commodity stocks, for example the London Stock Exchange’s FTSE. Any fluctuations in these markets can potentially shift the index price accordingly. 

How do you trade indices? 

When trading stock indices, it’s important to do your research, gain a good understanding of the product you’ve chosen to trade and to put into place the right risk management strategies. Of all the index trading products, one of the most popular is index CFDs. As we’ve mentioned, some financial instruments (like futures), require you to eventually take possession of the underlying asset, while others are purely speculative. Index CFDs are an example of a speculative financial instrument; they give you opportunities to profit from both rises and falls in a price index, by correctly predicting in which direction the overall price will move.

In general, there are two ways you can approach trading indices via CFDs: going long and going short. Going long refers to buying index trading products, because you think the price will rise. Going short means selling or closing your positions, because you expect the market to fall in price. 

Whether you decide to go long or short, your overall profit or loss when trading index CFDs will be determined by how accurate your prediction was and the overall size of the market’s movement. 

Leverage and index CFDs

The way CFD trading works is through leverage. If you’ve never used leveraged trading before, it’s important to understand how this differs from other types of trading. Leveraged products only require a small initial deposit in order to open a position – an amount known as a margin – which is calculated as a percentage of the overall actual value. 

Leveraged financial products may require less capital to give you exposure to a larger market, but it’s vital to remember that both losses and profits from index CFDs are calculated on the total value, not the percentage value of the margin. In practice, this means that it’s possible to incur a loss greater than your initial deposit. 

There are many strategies and approaches when it comes to how to trade CFDs, so you should carefully examine the particular CFD you’re interested in trading, and decide which strategy is best suited to your portfolio.

How to start trading indices

Once you’ve decided to trade indices, you’ll need to follow a few steps to get started operating in live markets. 

1. Decide what trade method you want to use — VT Markets offers traders the chance to trade indices CFDs, which allows you to identify opportunities to profit from both rising and falling prices.
   
2. Choose between cash indices and index futures — Generally, cash indices are favoured by day traders for their tighter spreads and on the spot trade pricing, while index futures take a longer term view, and incur less overnight funding chargers for traders looking to hold a position for a longer time span.
   
3. Create an account and log in — When you’re ready to go live, creating a live account with VT Markets only takes a few minutes.
   
4. Select the index you want to trade — Choose from the most popular global indices based on the available analysis and market insights.
   
5. Decide whether to go long or short — Remember, taking a short position means speculating on a decreasing index value, and going long predicts rising values for the index. Both can be the right call to make, depending on the overall outlook for a given economic sector or domestic market.
   
6. Set up risk management strategies — VT Markets offers our clients various automatic tools to prevent you from incurring losses you can’t afford. Stop-loss orders and limit orders are risk management tools you can use to ensure your position isn’t compromised by more or less favourable market prices.
   
7. Open your first position — See an opportunity? Seize it by opening and monitoring your first position. With trading tools and expert analysis from VT Markets, you can closely follow the market, closing out your position at the right time to maximise your profit or cut a loss. 

Diversify your portfolio and hedge your risk with VT Markets

As a full service online trading broker, VT Markets can connect you with the tools and powerful platforms you need to manage your trade positions, diversify your portfolio and manage your risk. Looking to trade Forex, or wondering which trading strategy is right for you to get started with? Get in touch with us today, or make a deposit and start trading your positions with expert market insights. 

FAQs

What are the best indices to trade for beginners?

A good rule of thumb for all trading is that more volatility equals both more opportunity and more risk. If you are a beginner to the world of trading indices, you may want to avoid more volatile markets and trading hours, in order to simplify the amount of decisions you’ll need to make and information you’ll have to make sure you’re across before opening or closing a position. 

Novice traders will therefore want to choose indices which have lower intraday trading volatility. The major national price indexes are good options for this; for example the ASX 200, S&P 500 or the DAX 40. These indices are generally considered to have easy to spot trends and are popular markets. 

Another way to increase your skill at trading indices is to practise with a demo account. At VT Markets, we offer a risk-free 90-day trial period with no obligations, so you can practise opening and closing positions with your chosen index CFD in a live trading environment.

What time are the stock market indices available to trade?

Unlike Forex trading on the foreign exchange which remains open 24 hours a day, 5 days a week, stock market indices operate on local time schedules. By using a powerful trading platform like MetaTrader 4 or MetaTrader 5, you can easily monitor the opening and closing times of local prices, and make your move during their volatile opening hours, or play it safer with a strategy of opening and closing positions later in their specific trading day.

What’s the difference between index trading and stock trading?
Index trading relies on speculation about indices, which are baskets of many stock prices of companies which are listed on the same exchange. Stock trading, by comparison, is the buying and selling of a company’s stocks at their market price. The advantage of index trading is that the amount of stocks bundled together into that index can make it less volatile than trading the stock of a single company.

Index trading is a good option if you want to gain exposure to a growing economy, while stock trading can be useful for traders’ portfolios during periods of slow or subdued growth.