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Module 1: Introduction to Indices Trading

Module 1: Introduction to Indices Trading
Module 1: Introduction to Indices Trading
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Module 1: Introduction to Indices Trading

Module 1: Introduction to Indices Trading

1.1 What are indices?

In investing, indices refer to benchmarks representing a segment of the market. They are made up of a hypothetical portfolio of various investment holdings, each organised according to predefined rules.

The word “indices” is the plural form of “index”. So, for example, a “Japan stock market index” would be a benchmark that measures the Japanese stock market. Meanwhile “Euro stock market indices” mean a set of benchmarks that are used to gauge the European stock markets. 

As you will soon see, there are many indices (or indexes) that are referenced by investors and traders who are interested in different markets. Some of these indices measure regional stocks, stocks by market capitalisation, company stocks across a sector, etc. 

1.2 Importance of indices in the financial markets

Ok, so we know what indices are, but what do they actually do? Why are they important?

Indices are highly useful in making sense of the conditions of a market. Take, for example, the S&P 500 Index. This index is composed of the largest 500 companies in the United States, across 11 major sectors. 

Because these companies – which include tech giants like Apple, Microsoft and Tesla, and household names like Visa, Johnson & Johnson and Coca-cola – are so powerful, influential and important to the American economy, their performance can be taken as a proxy for the overall state of the US stock market. 

Indeed, the S&P 500 proved to be such an accurate benchmark that it has become the de facto index when referring to the US stock market. Today, the performance of the S&P 500 is acknowledged as one of the major indicators of the health of the US economy. 

Why trade indices?

Technically, investors cannot trade an index, as it is merely a benchmark, and not an actual security. However, indices are used to create index funds, which are investment funds that mirror the composition of the index they represent. 

By investing in index funds, investors can attempt to replicate the returns of the underlying stock market index. For instance, the Vanguard S&P 500 ETF (VOO) is an exchange-traded fund that tracks the S&P 500 index. Investors can trade VOO to potentially capture returns in line with the performance of the S&P 500. 

Besides index funds, another way to trade market indices is via financial derivatives, such as Contracts-for-Difference (CFDs) or options. We will discuss the differences between both methods later on in the module. 

Pros of trading indices

Convenience

By trading a market index, investors can gain exposure to a pre-defined collection of stocks without having to research and analyse several individual stocks themselves. 

Furthermore, indices are updated regularly as companies shuffle around in market capitalisation, which means investors are always keyed into the latest market conditions. Thus, they can passively ride the performance of a market index without having to do anything – a strategy especially suited to long-term investing. 

Diversification and portfolio management

Indices are organised along several categories, including geographic region, market sector or industry and market capitalisation. By choosing a few different indices that have low levels of overlap, an investor can diversify their portfolios to hedge against risk.

Indices are also grouped by type of security, which opens up additional possibilities for portfolio management. 

For instance, one might balance an investment in the S&P 500 index with an investment in a bond index fund – achieving the classical stock-and-bond portfolio strategy. Similarly, you could also match your market index fund with a real estate index fund as a hedge against inflation.

Low cost

Index funds have some of the lowest fees compared to other securities, allowing investors to enjoy low-cost investing. VOO, which tracks the S&P 500, has an expense ratio of just 0.03%, for instance. 

However, note that this does not apply when trading indices using derivatives such as CFDs or options, as these come with different fees and charges. 

Cons of trading indices

No active management

Index funds track the performance of underlying indices, which can cause investors to be exposed to higher levels of volatility they may be comfortable with.

When the market is falling, index funds also decline, causing portfolio losses. In contrast, with a comparable portfolio composed of individual stocks, poor performers can be sold off in a downturn to temper volatility. 

Limited upside potential

Because an index fund is diversified across many different companies, the potential for outsized gains is limited. Index funds are unlikely to match the performance of a more narrowly focused portfolio that makes the right calls on individual stocks or sectors with exceptional performance. 

Vulnerable to systemic risks

Index funds are vulnerable to systemic risks that affect the market, such as economic or political developments that lead to market crashes. 

Tracking errors and overnight gaps

Due to factors such as fees, transaction costs or low liquidity, index funds may not perfectly replicate the performance of their underlying indices. Also, as indices can be impacted by global news and events, there can be a significant difference between the closing and opening of trade, causing the risk of overnight gaps to investors. 

1.3 Major indices from around the world

Each country’s stock market is represented by at least one index, with highly developed markets having several. Here’s a look at some important market indices around the world. 

United States

S&P 500 [1]

Perhaps the most well-known index of all is the S&P 500. As explained earlier, this index tracks the performance of the top 500 companies in the US, and has become a universal shorthand when discussing the US market and economic status.

This is because the S&P 500 represents about 80% of the American economy by market capitalisation. The median market capitalisation is about US$30 billion, with the highest at US$2.95 trillion at the time of writing. 

The constituents of the S&P 500 are weighted according to market cap at a flat rate. The index is rebalanced four times a year, in March, June, September and December. 

Here are the top 10 holdings in the S&P 500 at the time of writing. 

CompanySector
Microsoft Corp. (MSFT)Information Technology 
Apple Inc. (AAPL)Information Technology 
Nvidia Corp (NVDA)Information Technology
Amazon.com Inc (AMZN)Consumer Discretionary
Meta Platforms, Inc. (META)Communication Services
Alphabet Inc A (GOOGL)Communication Services
Alphabet Inc C (GOOG)Communication Services
Berkshire Hathaway B (BRK.B)Financials
Tesla, Inc (TSLA)Consumer Discretionary
Broadcom Inc (AVGO)Information Technology 

Dow Jones Industrial Average

The Dow Jones Industrial Average (aka The Dow) is another well-known benchmark of the US stock market. It is a price-weighted index of the top 30 blue-chip companies in the United States, covering all industries except transportation and utilities.

Some recognisable names listed in The Dow include Walmart, JP Morgan Chase, Microsoft, Coca-cola, Nike, Apple. Visa, Walgreens and Cisco Systems. [2] 

The Dow Jones Industrial Average is weighted by price, and updated in real time. Here’s the index’s breakdown by sector at the time of writing: [3]

SectorPercentage of index
Financials21.5%
Information Technology19.7%
Healthcare19.1%
Industrials14.0%
Consumer Discretionary12.9%
Consumer Staples7%
Energy2.5%
Communication Services2.4%
Materials0.9%

Nasdaq 100 [4,5]

The Nasdaq 100 is a stock market index of the 100 largest non-financial companies listed on Nasdaq exchanges. It includes companies in the following sectors: materials, consumer discretionary, consumer staples, health care, industrials, technology, telecommunications, utilities. 

What’s unique about the Nasdaq 100 is its focus on innovative companies, and its exclusion of financial companies such as investment banks. At present, the index is heavily weighted towards technology companies, and is thus a popular barometer for the technology sector on a whole.

The Nasdaq 100 is rebalanced four times a year, and employs a market capitalisation weighting. This means that larger companies are accorded a higher weight on the index, and changes in the price of larger companies will have a larger impact on the index. 

Here are the top 10 holdings of the Nasdaq. 

CompanySector
Apple Inc. (AAPL)Information Technology 
Microsoft Corp. (MSFT)Information Technology 
Amazon.com Inc (AMZN)Consumer Discretionary
Broadcom Inc (AVGO)Information Technology
Meta Platforms, Inc. (META)Communication Services
Nvidia Corp (NVDA)Information Technology
Tesla, Inc (TSLA)Consumer Discretionary
Alphabet Inc A (GOOGL)Communication Services
Alphabet Inc C (GOOG)Communication Services
Costco Wholesale (COST)Consumer Staples

United Kingdom

FTSE 100 [6]

Over in the United Kingdom, the prime stock market index is the Financial Times Stock Exchange 100 (FTSE 100, aka the “Footsie”). This index tracks the 100 largest companies by market capitalisation that are traded on the London Stock Exchange, and is as highly regarded in London as the S&P 500 is in America.

The Footsie includes companies from all sectors, and does not exclude non-British companies. However, they must be listed on the London Stock Exchange. 

The index is rebalanced every quarter to ensure it is tracking the companies with the highest market capitalisation. Here are the top 10 holdings on the FTSE 100. 

CompanySector
Natwest Group (NWG)Financials
Antofagasta (ANTO)Materials
Lloyds Banking Group (LLOY)Financials
Weir Group (WEIR)Industrials
IMI Plc. (IMI)Industrials
Rio Tinto Plc  (RIO)Materials
Prudential PLC (PRU)Financials
St James Place Plc (STJ)Financials
Rentokil Initial (RTO)Consumer Discretionary
Ashted Group Plc (AHT)Industrials

Germany

DAX40 [7]

The main stock market index for Germany is the DAX Stock Index (aka DAX40). It tracks 40 of the largest companies and most liquid German companies that traded on the Frankfurt Exchange, representing around 80% of the total stock market by capitalisation. 

Like the S&P 500, the DAX40 is widely referenced as a gauge of the economic health of Germany. It is composed of multinational companies that have significant domestic and international influence. 

Unlike other indices, the DAX40 is updated with futures prices for the next day. 

The 10 largest holdings for the index is as follows: [8]

CompanySector
Adidas AGPersonal Goods
Airbus SEAerospace & Defence
Allianz SELife Insurance
Basf SEChemicals
Bayer AGPharmaceuticals & Biotech
Bayerische Motoren Werke AGAutomobile & Parts
Beiersdorf AGPersonal Goods
Brenntag SEChemicals
Continental AGAutomobile & Parts
Covestro AGConstruction & Materials 

Australia

ASX 200 [9]

For Australia, the main stock market index is the ASX 200. As its name suggests, this index tracks 200 largest stocks by float-adjusted market capitalisation listed on the Australian Securities Exchange. 

The index is published by S&P Dow Jones, and is considered the main benchmark for Australian markets. Both primary and secondary listings are eligible for inclusion in the ASX. (Secondary listings are by companies which have their primary listings in another country or stock exchange). 

In terms of weighting, ASX adopts a float-adjusted market capitalisation method. This means that locked-in shares not available for trading are excluded from the calculation of market capitalisation, ensuring that the index is highly liquid so as to better fulfil its stated purpose as a leading market benchmark. 

Like many of its counterparts, the ASX is rebalanced four times a year to ensure accuracy. Its top 10 constituents by market capitalisation are as follows at the time of writing [10]

CompanySector
BHP Group (BHP)Materials
Commonwealth Bank Australia (CBA)Financials
CSL (CSL)Health Care
National Australian Bank (NAB)Financials
Westpac Banking Corp (WBC)Financials
ANZ Group Holdings (ANZ)Financials
Macquarie Group (MQG)Financials
Wesfarmers (WES)Consumer Discretionary
Woodside Energy Group (WES)Energy
Fortesque (FMG)Materials

Hong Kong

Hang Seng Index [11]

The Hang Seng Index is one of the largest stock market indices in the world, with a aggregate market capitalisation of more than USD 31 trillion as at December 2023. It is the main stock market index for Hong Kong, tracking top blue-chip companies listed on the Hong Kong Stock Exchange. 

The index employs a float-adjusted market capitalisation weighting, and does not specify a fixed number of constituents. Currently, there are about 82 companies included, representing around 65% of the total market capitalisation of the Hong Kong Stock Exchange.  

The Hang Seng Index is an important stock market index, widely considered to be the benchmark equity market index for Hong Kong, It is also often used as a general barometer of Asian markets.

The top 10 constituents of the Hang Seng Index are as follows as: 

CompanySector
HSBC (0005)Financials
BABA – SW (9988)Information Technology
Tencent (0700)Information Technology 
AIA (1299)Financials
CCB (0939)Financials
China Mobile (0941)Telecommunications
Meituan – W (3690)Information Technology 
HKEX (0388)Financials
ICBC (1398)Financials
CNOOC (0883)Energy
Table 1: Hang Seng Index Top 10 Constituents [12]

1.4 Market timings and global trading sessions

Stock markets do not trade around the clock. Instead, they are only open during regular business hours – from Monday to Friday, with Asian markets commonly taking a midday break for lunch. Most stock exchanges around the world do not open for trading on the weekend and instead operate a consistent weekday trading routine. However, stock market trading hours can differ depending on the culture and religious practice of a region. For example, various Middle Eastern stock exchanges are open on either Saturdays, Sundays or both.

The following table shows the trading hours of the world’s major stock exchanges. All times shown are in local time. [13]

Stock exchangeTrading hours (local time)
Australian Securities Exchange (ASX)10.00 – 16.00
Hong Kong Stock Exchange (HKEX)09.30 – 16.00
Frankfurt Stock Exchange (FSX)08.00 – 20.00
London Stock Exchange (LSE)08.00 – 16.30
Nasdaq09.30 – 16.00
New York Stock Exchange (NYSE)09.30 – 16.00
Shanghai Stock Exchange (SSX)09.30 – 15.00
Tokyo Stock Exchange (TSE)09.00 – 15.00

1.6 How indices are calculated

Stock market indices are calculated using various methods, depending on the type of stocks counted, and the goals of the index. Generally, there are three methods by which indices are calculated. 

Market capitalisation-weighted

The most common method of calculating a stock index is by market capitalisation. In this method, constituent stocks are ranked according to their market capitalisation – the larger the capitalisation, the higher the rank, and the greater the weight allocated to the stock. 

Thus, in a market capitalisation-weighted index, larger companies have more impact on the index. Should a company in the top 10 lose 1% market capitalisation, it would reduce the index more than, say, a 50th-rank company losing 1% market capitalisation. 

Market capitalisation is derived using the number of company shares multiplied by the share price. For stock indices, the most commonly used is float-adjusted market capitalisation, which excludes locked-up shares such as those owned by insiders or governments, or shares reserved for compensation such as stock options. 

Thus, only tradable shares are used in the calculation of market capitalisation, ensuring a more accurate and liquid index. 

Price weighted 

In a price-weighted stock index, constituent stocks are ranked according to share price. Specifically, the weighting of each constituent stock is equal to its stock price divided by the sum total of all share prices in the index. 

Thus, higher-priced stocks have more influence over lower-priced ones, and a large increase in a high-priced stock can cause the index to rise, even if several smaller stocks have fallen in price. 

Because of the way it is calculated, price weighted-indices are useful for gauging the average stock price of the market or sector it measures. 

However, as stock splits and share buybacks can alter a stock’s price without materially changing the status of the company, price-weighted indices require divisors to account for such changes.

Equal weight (aka unweighted) 

Equal-weighted indices are the most straightforward of the three. Constituent stocks are not ranked, instead a simple average is used to derive the value of the index. 

This means that no one constituent stock has more influence than any others, which dampens the effect of stock rallies or crashes. 

One example of an equal-weighted index is the S&P 500 Equal Weight Index (EWI), an equal-weight version of the S&P 500. This index offers an alternative for those who prefer to  trade indices with greater price stability. 

1.7 How to trade indices

There are two main methods to invest and trade in indices. Both have their benefits and drawbacks, and investors should consider their goals, preferences and risk tolerance when deciding which one to choose. 

Index CFDs

One way to trade indices is using Contract-for-Differences (CFDs). 

A type of financial derivative, CFDs allow you to speculate on the price movement of an underlying index. Based on your analysis of an index you choose, you can then open a trade according to your conviction of which way the price will go. At the close of the trade, the difference in price from the time the trade was opened is settled up,

WIth index CFDs, you can take both long and short positions, allowing you to potentially benefit from both bearish and bullish strategies. You can trade any index you wish, as long as it is offered by your brokerage. You may choose to use leverage, which allows trading with lesser capital, but know that trade outcomes – whether profits or losses – will be amplified. 

It’s important to understand that this method of trading indices does not entail any ownership of shares or stock. You will not be buying or selling any actual shares or stocks. Hence, you will not be entitled to shareholder rights such as dividends.

Index ETFs

Another method is to invest in exchange-traded funds (ETFs) tracking the performance of indices. These are also known as index funds, and are widely available at multiple online brokerages. 

With index ETFs, you buy and sell shares of investment funds that are set up to track the performance of an underlying index. These funds are designed to mirror the constituents of the indices they track, and offer similar performance. Their constituent stocks are rebalanced periodically by an asset manager to reduce the margin of error in tracking. 

The advantage of index ETFs is that you will be entitled to any dividends that the index pays out. You can also buy and sell ETF shares at your discretion, according to your investing goals. 

The drawback is that index ETFs incur an expense ratio – this is a fee based on a percentage of the total asset under management. While this can be as low as 0.03% (as in the case of VOO, a popular index ETF that tracks the S&P 500), you should still be aware of it. 

Another potential sticking point is that there is no leverage involved when investing in index ETFs, and that credible returns may take some time to materialise. Thuse, this method may not be suitable for those pursuing short-term investing strategies. 

Quick look: Indices CFDs vs Indices ETFs

Indices CFDsIndices ETFs
Does not have actual ownership of shares, cannot collect dividends Own shares of ETFs tracking underlying indices, entitled to dividends, if any 
Speculate on price movement of underlying indexTracks performance of popular indices
Can trade using leverage, which amplifies profits or lossesCannot use leverage when buying index ETF shares, returns may take time to materialise
Can start trading with very small capital, if using leverageCan start with as little as one share, or even fractional shares, depending on your brokerage
Trades tend to be short-term in nature, can choose short and long trades More suited to longer-term investments, capital losses can mount if too hasty in selling

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Module recap

  • Indices are used as benchmarks for stock markets. They are a hypothetical portfolio of various investment holdings, each organised according to predefined rules.
  • Indices may track regional stocks, stocks by market capitalisation, or company stocks across a sector, among others.
  • Because stock market indices track the performance of a selected segment of stocks, they are useful in helping to understand the conditions of a market. This is especially true for the major stock market indices that track the stock markets of various countries.
  • Some of the most popular stock market indices are S&P 500 (US), Nasdaq (US), FTSE 100 (UK), Hangseng Index (HK), DAX40 (Germany) and the ASX 200 (AU). Each of these may follow their own rules for choosing constituent stocks, but they all track the top performing companies listed on the respective stock exchanges. 
  • Most stock exchanges around the world do not open for trading on the weekend and instead operate a consistent weekday trading routine. However, stock market trading hours can differ depending on the culture and religious practice of a region. 
  • The three main ways of weighting stock market indices – in order of popularity – are market-capitalisation weighted, price weighted, and equal weighted. 
  • Market-capitalisation weighted indices rank constituent stocks according to the size of the company’s market capitalisation, which is derived by multiplying the share price by number of shares. 
  • Price-weighted indices rank constituent stocks according to share price. Such indices are useful for understanding the average share price of the market. 
  • Equal-weighted indices do not rank their constituent stocks – instead a simple average is used to calculate the value of the index. 
  • There is no way to invest directly in an index, as it is simply a benchmark. However, investors and traders may trade indices using either CFDs or ETFs.
  • Index CFDs are financial derivatives that allow speculation of the price movement of an underlying index. No actual ownership of any shares are involved, and both long and short trades may be made. 
  • Index ETFs are investment funds set up to track the performance of an underlying index. You can purchase and hold shares of an index ETF as an investment, and make capital gains when the index rises. If the index falls, selling your holdings will incur a loss. 

References

  1. “S&P 500 – S&P Dow Jones Indices”. https://www.spglobal.com/spdji/en/indices/equity/sp-500/#data. Accessed 16 April 2024.
  2. “Dow Jones Industrial Average – Barron’s”. https://www.barrons.com/market-data/indexes/djia. Accessed 16 April 2024.
  3. “Dow Jones Industrial Average – S&P Dow Jones Indices”. https://www.spglobal.com/spdji/en/indices/equity/dow-jones-industrial-average/#data. Accessed 16 April 2024.
  4. “Nasdaq-100 Index – Nasdaq”. https://www.nasdaq.com/docs/nasdaq-100-index-product-guide. Accessed 16 April 2024.
  5. “Nasdaq 100 – Nasdaq”. https://indexes.nasdaqomx.com/docs/FS_XNDX.pdf. Accessed 16 April 2024.
  6. “FTSE 100 – London Stock Exchange”. https://www.londonstockexchange.com/indices/ftse-100. Accessed 16 April 2024.
  7. “DAX Stock Index: Definition and Member Companies – Investopedia”. https://www.investopedia.com/terms/d/dax.asp. Accessed 16 April 2024.
  8. “DAX 40 Constituents – DividendMax”. https://www.dividendmax.com/market-index-constituents/dax-40. Accessed 16 April 2024.
  9. “S&P/AXS 200 Index – Investopedia”. https://www.investopedia.com/terms/s/sp/asx-200-index.asp. Accessed 16 April 2024.
  10. “S&P/ASX 200 – S&P Dow Jones”. https://www.spglobal.com/spdji/en/indices/equity/sp-asx-200/#overview. Accessed 16 April 2024.
  11. “What Is the Hang Seng Index (HSI)? – Investopedia”. https://www.investopedia.com/terms/h/hangseng.asp. Accessed 16 April 2024.
  12. “Hang Seng Index Factsheet – Hang Seng Indexes”. https://www.hsi.com.hk/static/uploads/contents/en/dl_centre/factsheets/hsie.pdf. Accessed 16 April 2024.
  13. “A Guide to Stock Market Trading Hours – Century Financial”. https://www.century.ae/en/guide-to-stock-market-hours/. Accessed 16 April 2024.
Module 1: Introduction to Indices Trading