Stock Market Trading - Understanding the Index

Like most financial markets, the world’s collection of stocks and equities has grown at an exponential rate throughout the digital age.

This is borne out by the numbers, which show that the total market capitalisation of equity backed securities rose from just $2.5 trillion in 1980 to a staggering $70.75 trillion by December 31st, 2019.

Interestingly, stocks are often organised and traded through indexes, which play a key role in facilitating investments and identifying trends. By what is an index and how exactly does it work?

What is a Stock Market Index? 

In general terms, indexes are created to track a variety of asset classes, from stocks and shares to bonds and even consumer prices for common goods and services.

More specifically, a stock market index is created to closely track the performance of any individual aspect of the market, from the value of the 500 biggest companies in a particular region to the real-time rate of inflation.

Not only can investors trade stocks and indexes directly, but these entities can also be used to monitor market performance in a number of different ways. In this respect, stock market indexes serve as key and insightful barometers, particularly when trying to appraise factors such as price movements and overriding market trends.

How do Stock Market Indexes Work? 

Before we delve into how indexes work, it’s important to understand precisely how they differ from investing in traditional stocks.

The key difference lies in the risk profile, as investing in single stocks means that you’re exposed to the larger number of risks that may face an individual company.

Conversely, stocks market indexes offer far greater market coverage and are automatically diversified, particularly when you seek out reputable entities that are available through licensed trading platforms.

In terms of functionality, the first thing that will strike you is the different types of index accessible to investors. Some may be divided by country, for example, with the German Index DAX 30 and the FTSE 100 offering relevant cases in point.

Some also feature stocks from specific industries, with the Nasdaq Index in the US (which deals exclusively in the technology sector) one of the best examples of this.

The value of these indexes is determined by a specific calculation, which factors in the performance of individual stocks before creating a weighted average. This is built on a relatively simple equation, which is displayed as follows:

Share price x number of shares / market capitalisation of all shares

As we can see, the value of an index will fluctuate widely in line with the underlying assets that this displays, providing telling insight for investors across the board.

What are the Pros and Cons of Trading Stock Indexes? 

Clearly, stock market indexes provide an accurate gauge for a particular market’s performance, while we’ve already touched on its capacity for creating a naturally diversified portfolio.

It can also be argued that indexes provide a less expensive investment option, while you can also access this broad asset class without having to compromise on market coverage or your individual exposure levels.

However, there are some potential cons to consider before deciding to trade stock market indexes, particularly from the perspective of novice investors.

One example is provided by the slight variations used to weight and calculate index funds, which may create confusion and make it hard to determine value in real-time. By targeting a single index, you may also find your options relatively restricted by country or industry, creating a less flexible portfolio over time.

Some evidence has also suggested that stock market indexes deliver lower returns than actively-managed funds in some instances, so you’ll need to make an informed choice when deciding how to invest your capital.

Author's Bio:

Craig Harbour is a senior digital marketing executive specialising in content coverage within a number of industries such as forex, finance, tech and automotive to name a few. As well as this, experience in onsite optimisation, brand awareness and technical SEO.