Stock indices are a hugely important part of the financial markets, with indices like the Dow Jones and NASDAQ among the biggest names in the financial world. So what are stock indices, and how do they work?
A stock index is a measurement of the price performance of a group of shares from a particular exchange. The FTSE 100, for example, represents the 100 largest stocks trading on the London Stock Exchange. If those stocks increase in price, the FTSE 100 goes up. If those stocks decrease in price, the FTSE 100 goes down.
Stock indices are typically calculated in one of two ways. The majority of global indices are capitalisation-weighted, which means that a company with a higher market cap (or total value on the market) has a greater impact on its index’s price.
However, some major indices – like the Dow Jones – are price-weighted, which means that a company with a higher share price affects the index’s price more. In a price-weighted index, for example, a company with a share price of $100 will have ten times the influence of a company with a share price of $10.
Because they are purely notional, the only way to trade an index is via a product that mirrors its performance. These products can include index funds, ETFs, futures and CFDs.
It is important to manage your risk when trading indices, as trading indices means trading a derivative instead of a physical asset.