Indices

What are Indices?

Indices are tools used to measure the performance of some group of similar assets in a measured and standard way. Most people recognize the indices that are used to measure the performance of a basket of equities. These indices are often meant to replicate the performance of a market sector. Some indices are broad-based like the S&P 500 and the Russell 2000, but others are more focused on a specific market sector or industry.

While indices are most commonly recognized in equity markets, they can also be used to measure other data such as production, inflation, and interest rates. In many cases these indices are created to serve as a benchmark to evaluate the performance of individual assets or the return in a portfolio.

Popular Indices

While there are indices for most of the markets all across the globe, some are more popular than others. It should come as no surprise that these popular indices are from some of the world’s largest economies. Below are 6 of the world’s most popular indices:

• Dow Jones Industrial Average (DJIA) – measures the value of the 30 largest blue-chip stocks in the U.S.
• DAX 30 – tracks the performance of the 30 largest companies listed on the Frankfurt Stock Exchange.
• NASDAQ 100 – reports the market value of the 100 largest non-financial companies in the U.S.
• FTSE 100– measures the performance of 100 blue-chip companies listed on the London Stock Exchange.
• S&P 500 – tracks the value of 500 large cap companies in the U.S.
• Nikkei 225 – Japan’s biggest price-weighted index is comprised of 225 of the country’s biggest companies.

What Affects the Index’s Price?

The price of any index is based on the prices of all its individual components. So as the price of those components changes, so does the price of the index. However, there are different ways to calculate the price of the index and this will also affect the rate of change in the index’s price.

In most cases an equity index is calculated using the market capitalization of the underlying companies. Using this method will make large cap companies more important in the index and their price changes will have a greater impact on the overall index price.

Another way to calculate the value of an index is through price-weighting. The DJIA is calculated in this way and it means that companies with a higher share price get a heavier weighting in the index. In this case the changes in the higher priced equities have a greater impact on the value of the index.

Advantages of Trading Indices

Trading in indices can have some distinct advantages over trading in individual equities. Because an index is a basket of securities, its price movements are typically smoother and can be easier to predict. Clear patterns often emerge on the charts when trading in indices. Another benefit of the diversification in an index is that it makes them one of the least likely asset classes to suffer from manipulation. There are simply too many assets included in the index for anyone to manipulate the price.

Because the index is made up of so many different assets, they also feature diversification and money management built right in. And since indices have a smoother movement and less volatility than individual assets, they present less risk to traders.

The difference between ‘cash indices’ and ‘index futures’

Cash indices are the actual real-time value of the index and are often preferred by traders with a shorter time horizon. That’s because the cash indices often have tighter spreads and greater liquidity. Many day traders will use cash indices, closing out their positions at the end of the trading session to avoid paying overnight financing charges.

Index futures are contracts that are priced based on the future expectations of the market regarding the price of the underlying index. Index futures, like any futures product, have an expiration date. They also have no overnight funding charge and are typically preferred by traders with a longer time horizon who plan on holding their positions for a long period of time.