An index in finance is a statistical measure of the change in a securities market. Indices measure the performance of a basket of instruments in a market. Examples of indices are the Standard and Poor’s 500, Dow Jones Industrial Average, Nikkei 225 and the Financial Times Stock Exchange 100.
Indices are used to gauge the overall performance of a group of securities. As such, the constituent elements are weighted in relation to each other. This weight is used in calculating the overall value of the index. It also spells out the impact changes in the different constituents will have on the overall.
Calculation of Stock Indices
Stock indices are calculated in two ways. These are capitalization-weighted and price-weighted.
Capitalization-weighted Indices: In capitalization-weighted indices, companies with higher market capitalization have a higher impact on the index price. While companies with lower capitalization, have a lower impact. An example of this is the S&P 500.
Price-weighted Indices: In price-weighted indices, the company with a higher share price has a higher impact on the index price. Examples are Nikkei 225 and DJIA.
How to trade
An index can be traded by using a derivative based on them. These derivatives can be anything from index funds to futures to ETFs and CFDs.
In order to trade these derivatives, the following must be done.
- Find a broker offering a derivative of the index of interest.
- Open an account with the broker.
- Fund the account.
- Trade away!!!
In conclusion, an index is a good way to monitor a group of securities. These securities have varying impact on the index. And finally, the index can be traded, for profit by trading a derivative.
Please do note that when dealing with a security you are not familiar with, always tread with caution.
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