Index trading is just one of the many ways to trade in the stock
market. It has a lot of advantages for
many investors, though, of course, those advantages come with inherent
downsides which the investor should be able to know.
What is Index Trading?
When we say ‘index’ in stock market terms, we’re referring to
a collection of stocks of various companies that are pooled together. The purpose of ‘indexing’ is to get a feel, or
a general idea, of how the sector or industry is performing.
It doesn’t necessarily mean that all companies under the
sector or industry should be in the index. What the index fetches are those that are ‘representative’
of the sector or industry. In other
words, the stocks of the businesses that are the main contributors to that
particular sector in one economy are pooled together to form an index.
If the index shows strong performance, it means that the sector
is bullish, or the prices of the stocks have risen. If the value of an index has dropped, it
tells you that the market is bearish at the moment or that the prices of the
stocks have also fallen.
[SEE ALSO: Market Sentiment: Bearish vs. Bullish]
[SEE ALSO: Market Sentiment: Bearish vs. Bullish]
Methods of Index Construction
If you’re planning to invest in an index in a wise way, you
should first be able to understand how it is constructed.
If a company aims to be included in an index, it first has
to meet specific criteria. Apart from
that, the business should also be able to consistently maintain the said
criteria. Failing to do that would mean
they can be replaced by another stock that can meet the criteria and maintain
them.
The moment the company is included in an index, the company
will be given a certain weightage. The weightage
tells something about the company’s ability to regulate that index. For instance, if company A has a weightage of
5 percent in an index, that means the company can affect the index by 5
percent.
Index Trading vs. Share Trading
One good thing about index trading is that it gives you
exposure to the companies that are all included in the index. If the index has 500 companies under its
wings, then you’re exposed to all those companies.
On the flip side, share trading enables you to invest only
to the stocks of a single company without being exposed to other companies’
stocks that are traded in the market.
Therefore, investing in an index of wide-ranging companies
to be exposed to as many stocks as possible is a very good way to diversify
your investment portfolio.
[READ FURTHER: Beginner's Guide to Stock Trading]
[READ FURTHER: Beginner's Guide to Stock Trading]
Risks
On the other hand, index trading can be highly risky if you compare
it side by side with other investment vehicles.
Since it sports the stocks of the biggest companies in the
entire market, an index can be highly speculative and volatile. A minor price fluctuation in the stock of any
of the company can negatively affect the whole market trend, dragging down the share
price of other companies.
In addition, index trading is quite costly because you’re
investing in some of the biggest companies.
That simply means you stand to lose huge amounts of money when you
invest in indexes.
If you’re not sure about how indexes behave and the factors making
it risky for you, it might be a good idea to ask for a professional broker’s
opinion or advice.
Conclusion
Index trading gives enormous rewards to those who do index
investing properly. However, it’s also
very risky. Before you jump in, make
sure you learn something about risk management, risk tolerance, and rules of thumb that will help you stay in the game for the long haul. You might even want to check other options
you have like mutual funds and exchange-traded funds, which also have their own
advantages and disadvantages.
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