What is a stock market index?
As well as being able to trade stocks in a company, you can also trade what is called an index, buying and selling it just as you would an individual share.
An index comprises a group of companies and bases its price on an average share price of the entire group.
For example, the price of the S&P500, which is a US index, is based on the share price of 500 different companies.
There are many different indices and each use different formulas to determine the index's price.
Different indices also specialise in different sectors. The NASDAQ Biotechnology Index, for example, includes only biotechnology research companies.
Price-weighted and market-weighted indices
There are two main kinds of index, with each using a different formula to determine the index's price.
Market value/capitalisation weighted indices base the weighting that a company has in the index on the company's total market value.
Basically, the bigger the company, the bigger the influence they will have on the index as a whole. Market value weighted indices are the most common type. The FTSE100 is one example.
Price-weighted indices base the weighting that a company has in the index on the company's share price.
If a company has a high share price, for example, any changes in that share price will have more power to move the overall index than will changes in a company whose share price is low. The Dow Jones Industrial Average is one example of a price-weighted index.
Using indices to trade a region
Indices tend to be region based and each index can be used as a gauge of a particular economy's health.
This is because the price of an index falls when the shares of the companies listed on it are falling, indicating that there could be something wrong with the economy overall or with parts of it.
The FTSE100, for example, is often used as a bellwether of the UK economy.
If you believed the economic outlook for the UK was negative, for example, you could short sell the FTSE100 index in the expectation that companies in the UK would do badly, dragging down the price of the index.
Other popular regional indices are the DAX30 in Germany and the CAC40 in France.
Using indices to gauge market sentiment
As well as reflecting the overall health of an economy, indices can give you an idea of the prevailing market sentiment. This helps you weigh up whether other investors are generally bullish or bearish.
Note that market sentiment is not always rational and does not necessarily move in line with the economy, although there is a relationship between the two. It has more to do with investors' appetite for owning risky assets like shares and can occasionally rise even when the economy is performing poorly.
Imagine, for example, you have been watching a FTSE-listed company and based on your analysis of its prospects you are keen to invest in it. However, the FTSE index then starts to fall. This could suggest to you that now is not a good time to buy those shares.
This is because the individual company's share price might get dragged down by negative market sentiment rather than because of any fundamental weakness in that company. It might be better to wait until the index overall is rising, allowing you to ride an uptick in sentiment.
Using indices to trade sectors
Lots of other indices focus on a particular industry or sector.
These indices allow you to form a view on whether a certain industry has good or bad prospects and trade on the basis of that.
If, for example, new regulations in the US threaten the ability of banks there to turn a profit, you might sell the KBW Bank Index. This index consists of the stocks of 24 banking companies from across the US.
If, alternatively, you thought that a rebound in Chinese economic growth might push up metals prices and improve the prospects of mining companies, you could buy the FTSE 350 Mining Index of big, FTSE-listed miners.
Although an indepth knowledge of a certain industry will certainly help you here, it is also possible to trade sector indices based on the overall state of an economy.
Certain business sectors are considered defensive, in that demand for their products remains stable even during times of recession. Examples of defensive sectors include the pharmaceutical industry, utilities and food producers.
Other sectors are considered cyclical, in that they perform better during periods of economic growth and can suffer during a downturn. Examples of cyclical sectors include the construction industry.
You could therefore decide to buy or sell certain sector indices based on how the overall economy is doing and what its future prospects appear to be. In a downturn, for example, you might sell cyclical sectors, and buy defensive sectors. In economic boom times, you might buy cyclical sectors.
In this lesson you have learned that:
- an index comprises a group of companies and bases its price on the average share price of the entire group.
- you can trade buy and sell indices in the same way as you trade an individual share.
- market-weighted indices base the weighting that a company has in the index on the company's total market value.
- price-weighted indices base the weighting that a company has in the index on the company's share price.
- indices tend to be region based and each index can be used as a gauge of a particular economy's health.
- indices can give you an idea of the prevailing market sentiment and risk appetite for shares – this can help you decide when to buy or sellindividual shares.
- sector indices allow you to form a view on whether a certain industry has good or bad prospects and trade on the basis of that.
- trading sector indices that focus on defensive or cyclical businesses will also allow you to take a view on the overall state of the economy.