An equity index is a basket of securities which reflects the broader stock market for a country. Major indices include the S&P 500 (U.S.), Nikkei 225 (Japan), DAX 30 (Germany), Shanghai (China), and the FTSE 100 (U.K.), to name a few of the largest global markets. Each index has its own calculation for determining its value; typically, weighting each constituent based on its market capitalization, but in some cases the index is weighted by the price of the index component.
While traders and investors can’t directly participate in an index, there are instruments such as futures, exchange traded funds, index funds, options, and CFDs which allow them to benefit from the price fluctuations of the index.
How Are Equity Indices Traded?
Equity indices can be traded in a number of ways – futures, ETFs, index funds, options, and CFDs.
- Futures are a popular way to trade equity indices directly through various leading global futures exchanges. Most of the major world indices in Asia, Europe, and North America can be found trading on the CME, CBOE, Eurex, and the Japan Exchange.The advantage to trading futures is the near 24-hour/5-day a week access, so there are is very limited gaps in liquidity. Even though the underlying index has set trading hours each business day, futures continue to trade between the close and open the following day. One of the drawbacks is large margin requirements for full-sized contracts, which can cost several thousands of dollars for one contract. However, many of the largest, most liquid indices also have a ‘mini’ version which requires less capital to trade. It should be noted that margin requirements do present opportunity to carry large amounts of leverage, which in return can be a double-edged sword for better and worse. Futures positions can be established to take advantage of both a rising and falling index.
- Exchange Traded Funds (ETFs) are another highly popular way for investors to establish positions without having to become involved in the futures market. There are numerous funds which are listed on major stock exchanges which mirror popular indices. For example, in the U.S. the New York Stock Exchange (NYSE) offers numerous ETFs which track the movements of the world’s largest stock markets.A big positive for ETF trading is the ability to carry much smaller positions than in futures, requiring less capital and/or risk. One of the drawbacks is limited exchange trading hours. Due to the fact ETFs are traded during constricted hours there is overnight gap risk from the close of the exchange on one day to the re-opening of the market on the next business day. ETFs can be traded from both the long and short-side of the market.
- Index funds are managed funds designed to track the price movements of the underlying index. These types of funds are attractive because of low turnover on the portfolio which in return keeps fees low, while having performance which mimics the broad market. Due to the non-trading nature of index funds, these are aimed at investors with a long-term time-frame.A disadvantage is that most index funds are long-only and do not offer an opportunity to hedge against or take advantage of a market decline.
- Options markets are traded by both professional and retail investors. Options allow for an individual to limit risk to only the premium required to purchase a plain vanilla option. Low capital requirements, which varies significantly depending on the price of the option, is another attractive reason to trade indices via options.Options can be traded on both futures and ETFs. Due to the complexity, it is highly advisable that an individual sufficiently educate themselves before engaging in options trading. Options are used to trade the market from the long or short-side of the market.
- The advent of CFDs (Contracts for Difference) has allowed small traders and investors to become involved in equity indices at a fraction of the required capital needed to trade futures. A CFD is constructed from futures contracts, so in effect the individual is trading futures. They are available to most market participants outside of the United States.One of the major benefits to CFDs is that participants can trade with a much smaller margin requirement than what is needed in the futures market, where several thousands of dollars can be required to establish a trade.Just like futures, the near 24-hour/5 days a week nature of CFDs make them attractive from the standpoint of avoiding gaps from the close of the underlying market one day and re-opening on the next business day. As is the case with futures, traders can buy or short CFDs to take advantage of rising and falling markets.
What factors impact price fluctuations?
- Indices are comprised of a basket of stocks, and depending on how the index is constructed and the weighting of individual names in that index, a single stock or sector can have a material impact on the performance of the overall index. There is a large variety of fundamental factors which impact the stocks which make up an index.
- Macroeconomics and central banks play an enormous role in how equity indices move. Since the end of the financial crisis, central banks adding and subtracting liquidity from the economy and financial markets has become a large driver of stock markets. Depending on how factors such as GDP, employment, and inflation are faring, the world’s largest central banks make adjustments to their balance sheets and interest rates, and in some cases outright making purchases in their own stock markets.
- The stock market is often times regarded as a forward-looking mechanism. Many times a bottom and turn higher in the broader market proceeds the economy demonstrating signs of strengthening or recovering from a recession. Conversely, the stock market will decline prior to the onset of an economic slowdown or a recession.