In addition to company shares, you can trade an asset such as a stock market index. The index consists of a group of companies and reflects the weighted average price of their shares.

For example, the value of the S&P 500 (the United States index) is based on the price of shares of 500 companies.

There are many different indices, each of which uses different formulas to calculate their own value.

Also, indices can include companies in specific areas of activity. For example, the well-known NASDAQ stock index includes companies that are involved in biotechnology development.

Price-Weighted and Market-Weighted Indices

There are two main types of indices, both of which use a separate formula to determine the value:

• By market capitalization;
• By share price.

In the first case, the index is weighted by the total market value of the companies. That is, the larger the company, the more it affects the index’s value. This calculation method is the most common. An example is the FTSE 100, the leading index of the British Stock Exchange.

The second type is weighted based on the price of shares in the group of companies. The more expensive a company’s shares, the more they affect the price of the entire index. The well-known Dow Jones Industrial Index is a bright example.

Trading Regional Indices

Most indices are based on a specific region or country and can be used to assess the state of a specific economy. For example, if the FTSE 100 starts to decline in price, it would suggest problems in the UK economy, as British companies are included in this index. By the way, traders often refer to the FTSE 100 as the barometer of the British economy.

If you believe that the prospects for the UK economy are negative, you could open a short position to sell the FTSE 100 index in anticipation of further deterioration. If this happens, you could profit from it.

There are also other well-known regional indices. In France, this is the CAC 40, and in Germany – the DAX 30.

Indices as Indicators of Market Sentiment

In addition to reflecting the overall economic situation, indices can provide data on prevailing market sentiment. That is, they help understand what other investors and traders are betting on – growth or increase.

However, one should not rely entirely on market sentiment, as it often turns out to be irrational and does not always follow the economy, even though it is connected with it. Market sentiment is more often associated with whether investors are ready to take over risky assets. They can rise quickly even during an economic downturn.

Let’s say you’re looking at the shares of a company that is included in the Dow Jones index and want to understand how promising they are to buy. But then you see that the index has started to fall sharply. In this case, it would be most reasonable to temporarily abandon investments.

The fact is that the value of some companies’ stocks can fall solely due to negative market sentiment, and not because of real economic weakening. Therefore, it is better to wait until the information that provoked bad sentiment subsides and the index resumes its growth.

Trading Economic Sector Indices

Many indices are based on a separate sector or industry. They will allow you to better understand how promising certain sectors of the economy are. This can and even should be used as part of the analysis in trading.

For example, if a new regulation law is passed in the United States that could limit the profitability of banks, you can sell the Keefe bank index, as it includes the shares of 24 US banking corporations.

Or you noticed that the rollback of Chinese economic growth will raise the price of metal and increase the prospect of companies in the mining sector. In this case, you would buy the mining index called the FTSE 350. It consists of the largest mining companies.

Even with deep knowledge in any industry, you should not refuse to monitor indices.

Some sectors are protected from economic fluctuations due to the consistently high demand for their goods. Such sectors include, for example, food production, pharmaceuticals, and utilities.

Other sectors can develop only with overall economic growth and sag during a downturn. A good example is the construction industry.

Therefore, you can decide whether to sell or buy an index of a separate segment based on the economic state and forecasts. For example, during a downturn, you can sell cyclical segments and buy protected ones. During an economic boom, it is more profitable to do the opposite.