Almost all non traders are aware of the main European, US and Asian stock indexes, because they are reported in the news. However many traders and certainly most non traders do not know how the stock indexes are traded.
The first index was created by Charles Dow in May 1896. It has evolved into what we know today as the Dow Jones Industrial Average.
Before deciding to trade indexes it is important to understand the difference between index trading and stock trading.
Difference Between Stock and Index Trading
Stock trading is referred to trading stocks of specific companies, each with individual prices. Once bought you own the stock and it has to be transferred to you from the seller.
Index trading is trading a basket of stocks which make up the index, through one instrument. The index tracks a basket of stocks that are used as indicators of a general representation of the whole stock market (S&P500) or are a specialized segment of a stock exchange such as technology, such as the NASDAQ.
Once traders become experienced enough, they can decide whether or not to trade indices based on their experience and understanding of the advantages of trading indices over trading stocks/shares.
To trade indices you do not need the services of traditional stock brokerage company. In fact, it is possible to buy an index or sell an index through internet-based platforms/broker.
Hence market trading online has become increasingly popular and retail investors buy or sell indices either as investment or hedging tools to diversify their portfolio risks.
Trading stock indices is normally more rewarding to an investor or a trader because in general indices have a higher return than the stock market they represent partially or wholly.
Another big advantage is that trading indices requires a minimum of research when compared to investing in individual stocks. Just imagine if you decided to invest in all the companies in the FTSE100, you would analyze 100 companies and that would require weeks of work.
It would be too difficult to track every single asset traded in the country.
However, if you simply invest in the S&P 100 stock index comprising the same basket of stocks you would only need to do the technical analysis on the index itself and the index would only require passive management and no tax liabilities.
The stock indexes, however, cannot be traded directly and they are available for information only. Market data is available for the stock indexes, and they can be charted, but there is no way to make either a long or short trade on the actual stock indices.
We always hear a trader mention that they are long or short on the Nada, or the FTSE100, but they are not actually long or short on those 100 indexes. They are actually long or short on a futures or options market.
Futures and options are known as derivatives markets, because they are derived from the underlying stock index. There are futures and options markets available for all of the popular stock indexes.
Futures and options markets usually move in synchronization with their underlying stock indexes. It is, therefore, possible to chart the stock indexes while trading the futures or options markets.
There are some advantages to charting the stock indexes instead of the futures or options.
The stock indexes do not expire like futures and options contracts do, so traders do not need to update their charting to a new contract every months/trimester (depending on the type of market).
Also, the options markets are difficult to chart because they consist of many contracts with different prices, so charting the stock indexes instead allows trading multiple options contracts using a single chart.
An index is nothing more than a list of stocks; anybody can create one. Most popular index apart, there are literally thousands of other indexes, tracking various regions and industries.
What sets the big indexes apart from the small ones is the reputation of the company that puts out the index.
The most important thing is to choose markets that are applicable for your account size, risk level and trading style.