Stock Indexes: what are they? A Guide


08/02/2023 - 12:58

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What are stock indices, what are they for and why are they so important? A complete guide on their definition and functioning.

Stock Indexes: what are they? A Guide

Stock indices: what are they, what are they for and why are they so important?

If in general the term "index" refers to a measure, to better understand what stock indices are and what their importance is on the markets, it is necessary to make several additional clarifications, above all because there are different types .

In finance, the term "index" refers to a measure of change in a given market. In the case of equity markets, equity indices represent a real portfolio, a grouping of securities of a particular market or a portion of it. This means that you cannot invest directly in an index by buying parts of it, but in the securities included in it.

The definition and use of the term thus begin to be clearer but let’s go into even more detail by providing a complete guide on stock indices: what are they and why are they so important for the markets?

Stock indices: what are they? Definition

As already mentioned above, equity indices can be considered as portfolios of securities grouped according to different characteristics and by virtue of different parameters. Precisely because of the different weighting systems used, the securities acquire a different weight within the stock indexes.

Given that each index expresses the trend of the securities included in it, the improvement in the market performance of listed companies will also correspond to an improvement in the performance of the stock index and vice versa. In many cases the relative variation of the indices is more important than the numerical value (to the points) scored.

An index can track an economic sector or a particular stock market.
Stock indices help us evaluate the performance of the markets over a specific period of time, such as daily, weekly, monthly and so on. In this way, comparisons can be made and the so-called "sentiment" of the market, on which analysts base their forecasts, can be determined. Furthermore, the indices are also used as a benchmark for stock performance. For example, the Dow Jones Industrial Average index, calculated by combining thirty largest-cap stocks in the United States, is among the best known in the world. When it goes down, stocks lose value, and when it goes up, they get more expensive.

In theory, an index cannot be bought or sold directly. How come? Stock indexes are only indicators that move according to the evolution of the quotations taken into consideration. Yet the price movements of the main world indices are reflected in many financial products such as:

  • futures contracts,
  • ETF (Exchange Trade Funds),
  • CFD (Contracts for Difference),
  • index funds.

For this reason, terms such as "index investing" or "index trading" are used in the economic field.

Types of equity indices

As will certainly become clearer in the lines that follow, the composition of the stock indexes varies according to the parameter of reference taken into consideration. Based on the selection criteria, a stock index can be:

  • Equally weighted: the weighting factors are equal for all stocks in the index. The capitalization of the companies has no relevance and they all have the same weight;
  • Price weighted: the composition varies according to the price of the securities contained in the index; the higher the price of a security, the higher its weight will be. Although they are simple to calculate, they risk not fully representing the general trend since there is a disproportion in favor of the more expensive stocks which are more represented;
  • Value weighted: These equity indices are based on the market capitalization of listed companies. They are periodically adjusted and adjusted after corporate actions but have the advantage of fairly representing all stocks. They are the most used stock indexes on the market.

In addition to these 3 criteria, the indices can also be established by sector (such as the Nasdaq), or by geographical area (for example global and national indices).

There is also a final typology to take into consideration: that of sustainability indices. The latter take into consideration the securities on the basis of different criteria than the economic-financial ones. They generally group the stocks of companies considered the best in the field of sustainability and CSR.

European stock indices

On the European stock exchanges front, the most famous stock indexes are those of London, Frankfurt, Paris, Madrid and Milan. The London index is the FTSE 100, the German one is the DAX 30, the French one the CAC 40, the Spanish one the IBEX 35 and the Milanese one the FTSE Mib.

  • FTSE 100: share index of the 100 companies with the largest capitalization listed on the London Stock Exchange. Every 3 months, the components inside and outside the index are established.
  • DAX 30: share index of the 30 stocks with the largest capitalization on the Frankfurt Stock Exchange. Taking into consideration a few companies does not necessarily represent the vitality of the economy.
  • CAC 40: share index of the 40 most significant stocks by capitalization among the 100 largest listed on the Paris Stock Exchange. Although the 40 companies are French, 45% of their shares are in the hands of foreign investors.
  • IBEX 35: stock index, as well as main indicator of the Madrid Stock Exchange. Includes the 35 largest stocks by capitalization.
  • FTSE Mib: main stock index of Borsa Italiana which includes the 40 largest Italian companies by capitalisation. It came to life from the merger between Borsa Italiana and the London Stock Exchange, a move that led to the birth of the London Stock Exchange Group.

World Stock Indices

In addition to the main equity indices of Italy and Europe, it is also worth mentioning the Asian and American ones. To the east we find the Nikkei 225, which is quite broad compared to its European peers as it includes the 225 largest Japanese stocks by market capitalization.

Also in Asia we find the Shanghai composite, which takes into consideration all the securities of the Chinese market. It is divided into SSE 380, SSE 180 and SSE 50 according to the number of companies taken into consideration.

Also worth mentioning is the Hang Seng of Hong Kong, made up of 50 companies that represent 58% of the capitalization of the entire Hong Kong Stock Exchange. Finally, among the Asian equity indices, the South Korean KOSPI cannot be overlooked, which refers to more than 780 companies including Samsung and Hyundai.

There are 3 main American stock indexes: Dow Jones, S&P 500 and Nasdaq. The Dow Jones Industrial Average (DOW 30) is made up of 30 stocks but, contrary to what we have seen so far, it does not refer to the capitalization of listed companies, but to the price of the stocks.

The S&P 500 was born in 1957 at the hands of Standard & Poor’s. Also in this case, the reference value is the capitalization of the 500 largest US companies: due to its size, it is the main reference stock index of the US markets.

Finally we have the Nasdaq Composite which, of all the equity indices, is the benchmark for Wall Street’s tech stocks.

Investing in Stock Indices with CFDs

You can buy a CFD based on a particular index rather than buying or selling all the shares that are included in that index.
In the event that we believe that an entire market may go higher, we can buy a CFD with support on an index. If, on the other hand, we believe that that market will go down, we can sell the underlying CFD on that index. In this way it is possible to trade on the general trend - positive or negative - of a given stock market.

Contracts for difference have several advantages, including high liquidity, low entry thresholds, low transaction costs, also allowing you to diversify your investment portfolio. Short selling offers more flexibility and allows for the implementation of different strategies. However, it is important to remember that by trading CFDs you do not become the owner of the underlying instrument but only speculate on price movements.

If you are interested in investing in CFDs on indices, it is advisable to evaluate the offer of XTB, one stop shop global broker, fourth in the world by number of active clients.

Warning: It is important to always keep in mind that CFDs are derivative financial instruments and, therefore, associated with greater risk. Furthermore, being leveraged instruments, not only is the amount of potential gains amplified, but also that of possible losses.

Original article published on Italy 2022-12-14 12:31:00. Original title: Indici azionari: cosa sono? La guida

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