How are stock indices traded?

A stock index is essentially a calculated value, rather than a physical asset that can be owned directly.

This means traders and investors need financial products that follow or derive their value from the index.

Before looking at those products, it helps to understand how indices are calculated.

How are stock indices calculated?

Different indices use different methodologies.

Two common approaches are:

Market-capitalisation weighting

A market-capitalisation-weighted index gives larger companies greater influence over the index.

A company's market capitalisation is generally calculated as:

Share price × shares outstanding

Suppose:

Company A is worth $100 billion.

Company B is worth $20 billion.

In a market-cap-weighted index containing both companies, movements in Company A would generally have more influence because it has the larger market capitalisation.

Many major global indices use some form of market-capitalisation weighting.

Price weighting

A price-weighted index gives greater influence to companies with higher share prices.

The Dow Jones Industrial Average is a well-known example of a price-weighted index.

How can investors gain exposure to an index?

Several financial products can track an index.

Index funds

An index fund aims to follow the performance of a particular index by holding a portfolio designed to replicate it.

Exchange-traded funds

An ETF can track an index while trading on an exchange similarly to a share.

Futures

Index futures are contracts whose value is linked to an underlying stock index.

CFDs

A Contract for Difference, or CFD, is a derivative whose price is based on the underlying market.

When trading an index CFD, the trader does not own the shares contained within the index. Instead, the CFD reflects changes in the underlying index price, subject to the relevant product terms.

Because derivatives may involve leverage, both potential gains and potential losses can be magnified.

What moves stock indices?

Index prices can react to:

• Interest-rate expectations

• Inflation

• Employment data

• Company earnings

• Economic growth

• Political developments

• Geopolitical events

• Investor sentiment

Because indices contain multiple companies, they can provide traders with broader market exposure than concentrating on one individual share.

Lesson summary

• Stock indices are calculated values rather than physical assets.

• Indices can be market-capitalisation weighted or price weighted.

• Investors can access indices through products such as funds and ETFs.

• Traders may use derivatives such as futures and CFDs.

• Economic data, company performance and market sentiment can move indices.