How can you get exposure to indices like the Dow Jones?
A stock index is the measurement of the price performance of a group of shares of a particular exchange. The Dow Jones Industrial Average (DJIA), for instance, is one of the oldest, most well-known and most regularly used index in the world.
There are many different indices globally, some providing exposure to major stocks in a country and some others specialising in a particular sector. For example, the NASDAQ Biotechnology Index includes biotechnology research companies, while the Straits Times Index (STI) comprises of large cap stocks in Singapore.
Calculating the price of an index
The price of an index is calculated in various ways, with the weighted average market capitalisation and price weighted basis being some common methods.
Under the weighted average market capitalisation, the index price is calculated based on the market capitalisation of shares in the index, or the index components. So companies with a higher market capitalisation will have a higher weightage in the index. The price of the FTSE STI is calculated based on market capitalisation.
With a price weighted method, index price is based on the average share price of companies that are part of the index. For example, a company with a stock-price of $1000 will have ten times the influence of a company with a price of $100. The Nikkei 225 is a price-weighted index.
Ways to gain exposure to indices
When speculating on the price of an index, we are predicting that prices would fall or rise without actually buying shares in the index. So just like stocks, we will typically buy at a lower price in anticipation of a price increase and sell it at a later time for profit, and vice versa.
Since indices are a representation of a group of companies, they cannot be traded directly. Investors can gain exposure to an index via instruments like futures, options, contract for difference (CFD) or exchange traded funds (ETF).
Trading Contracts for Differences (CFDs) on indices is one popular method. Here, investors will enter into a contract to exchange the difference in value of a particular index between the time they open their position and the time they close it. CFDs are leveraged products so investors only need to pay a fraction of the total contract value. As CFDs allow traders to go long or short, it can be a useful tool for hedging. For example, if one currently holds a long position on some shares, but expects short-term head winds in the market, an index CFD can be used to ride the short term downtrend.
Apart from that, investors can also trade indices through exchange traded funds (ETF). ETFs help in portfolio diversification. For example, the STI is made up of 30 companies which represent 77.29% of the total value of SGX-listed companies. By investing in the STI ETF investors would effectively own 30 of the best companies from different sectors in the country. ETFs offer benefits that are similar to mutual funds. As an investor, you would be able to invest passively without having knowledge of each and every stock.
Greater volatility than stocks?
When trading in indices, the value of index is affected by economic reports, geopolitical news or any sector related news. As an index comprises of stocks, news affecting these stocks would have an impact on the index, though to a limited extent. Hence, stock specific risks are lowered by the diversification that index trading bring.
To trade effectively speculate on the price of an index, an investor should have a thorough understanding of the industry and economy where the index components come from.
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This article was sponsored by IG, the world’s No.1 CFD provider (by revenue excluding FX, 2016). All views expressed in the article are the independent opinion of ZUU.