Indices Education

Trading the Indices

Investors and traders are obviously familiar with the concept of picking a share that will rise in value and benefiting from that increase in value and likewise, being able to pick which stocks will fall in value so they can short the stock to profit from that move. But what if you have a general view of the market but didn't want to pick out a particular stock to base your opinion on? You will be pleased to hear that you can trade Indices with Options, Warrants, Futures and CFDs.


What are Indices?

Indices EducationIndices are a broad index based on a set number of stocks within any particular market sector. The most important local index is the S&P/ASX 200. There will always be a fixed number of companies, 200, in this index. When a stock is removed, its position would be immediately replaced by another. The S&P/ASX 200 Index represents approximately 90% of the total market capitalisation of the Australian market. Indices provide investors and fund managers with an effective benchmark for equity performance, yet with an emphasis on broader representation.

A stock index is a hugely important part of our financial world, but it is nothing more than a number representing the top shares from a particular exchange.

For example, the FTSE 100 represents the largest 100 companies traded on the London Stock Exchange. If, on average, the share price of these companies goes up - then the FTSE 100 will rise with them. And if they fall, it will drop.

Other examples of stock indices include:

  • Dow Jones, Nasdaq and S&P (US)
  • DAX and CAC (Europe)
  • Hang Seng, Nikkei and ASX (Asia-Pacific)

Most of these are calculated using a capitalisation-weighted average, which means the size of each company is taken into account. The more a particular company is worth, the more its share price will affect the index as a whole.

However, the Dow Jones and Nikkei are price-weighted indices, where shares with higher prices have more influence. This means a stock trading at $100 is given 10 times more weight than one at $10.


The Benefits of Indices

Stability or Less Market Shock - Due to diversification within the broader national Indices, they have inherent stability as no one stock can completely influence the index. As such, one-off dividend announcements or general market announcements have little to no effect upon the index.

Liquidity Benefits Options and Warrants - There is a lot of activity on the indices which equates to liquidity. This allows more choice, either in the expiration date and/or the strike price of Index Options, and warrants. It also allows the trader/investor to enter and exit the index market more easily.

Greater Leverage - The instruments you use to trade Indices offer a greater leverage than they would on an individual stock. However, it must be noted that, as always, this brings greater risk as well as more profit potential.


How to Trade the Indices

There are many Indices that you can trade on; in fact you are able to trade 24 hours a day on the respective global indices. Each Index has its own patterns, volatilities and peculiarities and it is worthwhile ensuring that your trading style fits an Index before committing money to it. The following short paragraphs on Index Options and CFD's is based upon the Australian Index, called the XJO. Please note that you can also use Futures to trade the XJO and warrants for the XAO.


Index Options

Although similar in concept to Equity Options, XJO options only have Quarterly expirations (March, June, Sept, Dec). Also, Index options are European, which means they may only be exercised at expiry, whereas share options can be exercised at any time. They are also cash settled (as opposed to security settled for ETOs on equities). Moreover, the strike price is expressed in points, as is the premium. (1 point = $10. The strike price is at 25 point intervals).


CFDs

CFD's allow you to use leveraging to increase your exposure to the underlying movement in the Index. The main difference to CFDs on a stock is the level of leveraging; up to 100 to 1. This brings with it a large degree of risk which you should discuss with your financial adviser and be fully aware of before entering into a CFD agreement. Unlike Options, which allow you the right but not the obligation to the Option, CFDs are a binding financial contract.


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