Useful Things to Know About Index Trading

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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.

Indexes and numbers and trend lines


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]

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]

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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