What Are Indices?
Stock trading relies on a trader’s knowledge of the performance of specific companies. How can one individual keep track of thousands of companies? This is the rationale behind the creation of indices, which use samples of different stocks to represent the stock market as a whole. Traders who specialize in indices tend to believe that the theory that if a carefully selected basket of stocks is doing well, the market is likely to be doing well, and conversely if the basket is not performing well, the market outlook, in general, is poor. There are several different indices which can be chosen, but some of the most popular is the DOW, NASDAQ, the S&P 500, and the FTSE.
The benefit of index trading is that as long as you work with a trustworthy list, someone has already put forth the effort in picking stocks to watch. The analysts then review their performance and distill this information into an easily digestible number. The key is to pick the index that best represents the type of trading you wish to do. With a large number of companies, the risk that a single company’s earnings will be crippled by a Black Swan event is lowered significantly.
What are Some Popular Stock Indices?
The DOW basket of the top 30 companies that have an excellent reputation, but market movement tends to be lower because companies of this type put forth a lot of effort to minimize risk. Additionally, many of the DOW30 companies are in similar industries, so when one of them is facing difficulties, the same conditions could affect several other DOW30 stocks. This works against the market principle of diversification.
The S&P 500 is a much more varied basket of companies, as it samples a broader range of companies which are chosen by a committee. This means that the index is more susceptible to market fluctuations. This index is commonly referred to as the best measure of how the American economy is doing.
While the DOW and the S&P 500 are both widely traded, they are primarily indicators for companies located within the United States. For traders who are interested in the European economy, there is the FTSE, which tracks stocks that are traded on the London Exchange. Middle East stocks are covered by the Tadawul Index, which covers trading taking place on the Saudi Arabian exchange. Wherever your area of interest is located, there is an index designed to reflect the performance of that market.
What Are the Risks of Trading Indices?
Traditional index trading has many of the same risks as trading individual stocks. The trading frequently relies on an intermediary who takes a commission on each order. Therefore investors need to keep a close watch on prices so that they exit trades after they have made enough profit to recoup any fees, otherwise, they will still be trading at a loss. When the market moves quickly, there may not be enough time to get out of a trade without incurring losses greater than your original investment. Also, because there are so many companies included in an index, it is nearly impossible to do in-depth research. Index traders are more reliant on the opinions of analysts, who may give opinions on the overall state of the economy, and then make recommendations based on the likely impact of the market direction on an index based on the types of companies that are included. While this is a rational game plan, there is little possibility for oversight or correction in those cases where the financial experts have misread the indicators.
One way to reduce the risk of trading indices is to switch to trading CFDs online. With CFDs the initial investment by the traders is low, yet the profit he will make is relatively high. In addition a trader can make profit even if the index decreases, which is not a possibility in conventional trading. The CFD determines in which direction the value will move and the trader decides when to close the contract. He can do so at any given time, when he feels that the profit is high enough or as soon as he realizes, that the direction he chose was wrong or is going to change.