The definition of stock indices is one of the frequently talked about terms due to its importance because it will be challenging to keep track of every security traded. We take a smaller sample of the market that is representative of the whole – similar to opinion polls that use surveys to measure the population’s sentiment.
This smaller sample of the stock market is called stock indices, and it is a statistical measure of changes in a portfolio of stocks that is part of the market as a whole.
Investors and other market participants use global stock indices to track stock market performance.
Ideally, a change in the price of stock indices represents a completely relative change in the stocks included in the stock index. Where stock indices have increased by 1%, for example, it means that the stocks that make up this financial index have also increased by an average of 1%.
Let’s see how global stock indices work using a simple example: Let’s say we create an index to track the price of a gallon of milk.
Let’s say it costs $2.00 per gallon to consume milk. The initial index value is 1.00, or 1%.
When milk costs $2.50, our index will be 1.25, reflecting a 25% increase in milk price. If milk costs $2.25, the index is 1.15. The .10 change reflects a 10% decrease in the price of milk.
Relationships between stock indices and currencies
Currencies are the most difficult asset class to fit into the fixed or idealized market correlation model.
At first, in order to buy stocks from a particular country, investors have to pay in the local currency, which increases the demand for it.
Conversely, a strong currency makes bonds and stocks from that particular country look attractive.
However, the correlation is only sometimes clear, as there is a delay in the response between each of the reactions of the markets, forex, and stocks, which leaves the investor owning foreign stocks exposed to fluctuations in the exchange rate.
The correlation can also be fragile between the international stock indices themselves.
There are so-called “global aberrations” when the stock market in one country begins to perform better than the stock market in another country.
This is often caused by currency-driven capital flows from weaker countries relative to the stock market to countries with a more robust stock market.
Stock indices can be classified in different ways, but here we will focus on the two most essential classifications through which you can take a look at the most important types of these indices, which are:
National key global indicators
These indices represent the performance of securities in a specific country and reflect investors’ feelings about the country’s economic situation. National indices include shares of major companies listed on the country’s largest stock exchanges.
For example, when looking at the “FTSE 100” index, we see that it contains the shares of the hundred largest British companies listed on the London Stock Exchange, and it is not a condition that these companies are owned by the government. They can be one of the private sector companies. These are considered shares of the investors’ feelings towards the UK economy so far.
The same applies to the “Nikkei 225” index, which is located on the Tokyo Stock Exchange in Japan and represents the 225 largest Japanese companies.
The leading global indices in sectors
These indicators are more specialized as they track the performance of a specific stock market sector, and investment returns and risks for a specific sector can be measured through a detailed study of these indicators.
For example, the Morgan Stanley Biotechnology Index includes the 36 largest companies operating in the biotechnology industry, which represent the performance of this sector in the United States, through which investment in the biotechnology sector can be studied.
Global stock indices
We come to another part, which is what interests us as traders in the CFD markets, as many forex companies provide trading on global stock indices efficiently through CFDs, and the most important and most popular indices among traders:
- The Dow Jones DJ 30 Index includes the 30 largest industrial companies listed on the New York Stock Exchange, the most popular among traders, and the largest in terms of liquidity.
- The Nasdaq NQ 100 index contains the 100 largest companies operating in the technology sector in the United States, which we often hear about or use their devices daily, such as Apple, and the online shopping giant Amazon.
- FTSE 100 Index: This index is located on the London Stock Exchange and contains shares of the 100 largest British companies.
- The DAX 30 Index is one of the German indices and consists of the 30 largest companies on the Frankfurt Stock Exchange.
- CAC 40 Index: One of the leading indicators in the French market, which is widely known among traders in the Arab world.
- Nikkei 225 index: It is considered one of the leading indices on the Tokyo Stock Exchange in Japan and includes the 225 largest companies listed on the stock exchange.
Pros and cons of trading stock indices
The main global indices are used very widely by all those interested in market movements due to their positive aspects, but they may also carry some negatives. Below we review the most prominent of them:
Advantages of the leading global indicators
- Simplifies the research process: Stock indices lift the heavy burden for investors who want to know how an industry, economy, or sector is performing.
- Instead of having to find relevant companies and study their performance on an individual basis, investors can watch one index of these stocks.
- Investors are allowed exposure to commodities: Depending on the sector being tracked by the stock index, buying stock indices may be the only option for the average investor looking to gain exposure to specific markets.
For example, only some have the space to store barrels of oil or sacks of wheat. Alternatively, these investors can purchase the appropriate commodity index that tracks the market in which they want to buy.
Global stock index funds are easy to gain exposure to specific markets or sectors without placing thousands of orders.
Disadvantages of the leading global indices:
- Stock indices are not always accurate: While a stock ticker is designed to simulate a particular market, this does not mean that it is 100% accurate. Just because you buy a forex market index in a particular region, it does not mean that your basket will perfectly reflect that region’s economy. Many factors can change the course of an economy, and sometimes it is difficult for a stock index to account for all of them accurately.
- Stock indices only sometimes have liquidity: It can be challenging to trade in and out of certain positions, depending on which stock index you track. If you are trading an obscure index, finding someone willing to buy or sell the security you want to trade can take time and effort. However, this is fine, with many stock market indices consistently seeing high daily trading volumes.
- All of the negative aspects of other forms of investing also apply to investing in stock indices. This includes issues with order type – market orders will be executed quickly but will not guarantee price, while limit orders control the price at the expense of timing.
How is the value of stock indices calculated?
Before the digital age, index price calculation took work. Today, most global stock indices use the weighted average formula to determine the index’s value. In this system, the weight of each share is: Share price x number of shares/market value of all shares
Most indices weigh companies by market capitalization. If the market capitalization of Mahi is 1,000,000 EGP and the value of all shares in the index is 100,000,000 EGP, then the company is worth 1% of the index. This means that the value of a stock index is a statistical measure of changes in a portfolio of stocks that are part of the market.