An Introduction to Index Trading

Index trading can provide a popular asset for those looking to take economic advantage of changing macroeconomic trends. In this series of three hot topics, we’re going to take a closer look at what an index is, the different ways of calculating an index, some typical trends found in trading the asset and then also cover in more detail some of the popular indices which are on offer.

What is an index

An index is quite simply a basket of assets, which will typically follow some kind of common theme. That could be the largest listed companies in a territory, such as the FTSE-100 being a guide to performance of the 100 biggest companies listed on the London Stock Exchange. Equally however, the index can be sector specific – as an example, the Chicago Board of Exchange quotes 11 indices covering each of the industrial sectors in the S&P index. Indices don’t have to be limited to just shares, either. Popular non-equity indices include the VIX, which is a measure of the expected price fluctuations on the S&P 500 over the next 30 days, or something like the DXY Dollar Index, which illustrates the relative value of the dollar by comparing it to a weighted basket of other popular currencies. Note this is only a very small selection of the indices on offer in the market today.

How is an index weighted?

As noted above, indices can provide a broad guide to the fortunes of a sector, country or genre of investing, but it’s important to understand the way they are weighted. The most common format of weighting is based on market capitalisation of the constituents. That will need to be rebalanced on a regular basis, but in short, the companies which are worth the most will have the potential to exert the biggest influence on the index.

Some indices are equally weighted, where each constituent carries the potential for equal influence, regardless of its size. That can prove problematic in examples such as when an index includes both highly liquid and less liquid stocks. The latter has the prospect of making significant moves in either direction, often for reasons that are difficult to understand.

A third weighting method which used to be more common is price weighting, which looks at the absolute share price, rather than the market capitalisation. The best example of this now is the Dow Jones Industrial Average, or the US30, where Boeing is the heaviest weighted constituent, accounting for almost 9% of the index. The aircraft manufacturer has struggled in recent months following two fatal crashes and the accompanying big falls in Boeing’s share price have had a disproportionate impact on the index as a result.

Details of other pricing methods, including fundamentally and risk weighted indices, can be found here.

What purpose does an index serve?

Principally, the benefit of an index is that it allows investors in the broader sector to judge comparative performance. If an index is up 10% but a constituent is only up 5% over the same period, questions may be asked as to the drivers behind the underperformance. Something like the DXY Dollar index also allows investors to see the relative performance of the Greenback as a whole. As the dominant currency, attempting to judge its performance against something like the Japanese Yen or Swiss Franc is complicated as fundamental factors impacting the target currency also need to be considered. The DXY is a better judge of whether the dollar is rising or falling.

Advantages to index trading

So why would you want to trade an index? As noted above, indices afford the opportunity to trade on a broader macroeconomic picture. Picking a single stock that does well in a certain phase of the economic cycle, such as a bank when the economy is booming, is all well and good, but it fails to provide any protection against one bad set of results at that bank. Buying – or selling - the whole index provides diversification across all the constituents. Again, drawing from examples above, the chart below shows the performance of Boeing against the Dow Jones/US30 for the last six months

source:Bloomberg

Whilst Boeing had a great performance over the first six weeks, over the longer term the Dow has outperformed.

Other broad-based rules apply to index trading, too. In periods of low interest rates, investors will shift their bias from low risk, low return government debt into higher risk equities as they pursue yields. This equation is seen as responsible for driving the continued bull market on Wall Street – the prospect of rate cuts at the Fed means more demand for equities, and with lower interest rates, companies will be more compelled to invest for growth, too.

Another broad correlation is the FTSE-100’s performance with regard to that of the British Pound. Some 71% of earnings for companies in the benchmark UK index are generated in foreign currency, so when the Pound falls, the value of repatriated profits increases, in turn boosting the Sterling valuation of the company. So rather than trying to trade on the Pound’s ongoing demise, some investors may have elected to buy the FTSE-100 index instead.

Is it all good?

What we’ve seen so far is that index trading may well appear to be a powerful proposition. There’s plenty of choice, diversification ought to reduce risk and it’s a great way of getting exposure to a wider macroeconomic theme, but is it really a one-way street?

This form of trading isn’t entirely without challenges. Firstly, when you’re buying - or indeed selling – an index, it’s typically a binary approach. You’re getting the whole index. If you don’t want exposure to a specific asset in that index – maybe a stock that you believe is set to underperform badly - you’re getting it anyway. Indices can also be capital intensive to trade, with contract sizes based on the notional value of the index, but they do offer a great way of getting easy exposure to the big macroeconomic factors that are behind many a market move.

The information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.