Index trading is a financial trading strategy of buying or selling a stock market index rather than an individual stock, commodity or other asset. Tradable indices include the UK FTSE 100, German DAX and the US Dow Jones Industrial Average.
An index is essentially a collection of multiple stocks (e.g. 30, 100, 500, etc) representing a particular market or stock exchange. Investing in an index can serve as a proxy of investing in that specific market as a whole. There are many different indexes covering the diverse range of global markets.
Some indices (like FTSE 100 and DAX) are capitalisation-weighted. This means that the value of FTSE 100 increases with the growth of individual companies’ market capitalisation. Other indices like the Dow Jones are price-weighted. This kind of index is calculated by adding the prices per share of each company in the index and then dividing it by a total number of companies.
Because indices are not actual securities, but simply collections of prices of other stocks, you cannot buy or sell them directly, like a stock or a currency. Instead, investors trade index derivatives, such as futures, options, spread bets or contracts for difference (CFDs), which mirror the up and down movement of the index. A CFD is a kind of derivatives contract that is based on the future price of the index and can be traded on a ‘per point’ basis. For example, if you thought the FTSE 100 index was likely to go up, you can decide to “go £10 per point long” using CFDs. This means that for each point the index rises or falls, you’ll make or lose £10.
When index trading investors take a position in an index they are indirectly investing into the individual shares and companies that this index represents. This means that the relative success or failure of the constituent parts leads to the index to change accordingly.
Because an index is made up of many individual stocks, success or failure of a single company could have a limited effect on the index as a whole. This limits the trader’s overall exposure. If one FTSE 100 stock trades lower, but 99 others trade higher, an index trader’s relative position can still go up. Index traders have less concern for individual stocks and become more concerned with the market as a whole.
Traditional index trading was originally reserved for big financial institutions such as banks or brokerages; those with direct access to stock exchanges. The advent of the internet and electronic trading, however, has provided easier access for retail investors. Now could be the best time to get involved and establish yourself as an index trader.