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Index Trading

17.03.2021

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Stock index – a composite index calculated on the basis of the prices of a certain group of securities – the “index basket”.

When calculating an index, its initial (base) value can be the sum of prices or be equated to an arbitrary number (for example, 100 or 1000). To ensure comparability, prices are often multiplied by additional factors. Therefore, the absolute values ​​of the indices are not important. Changes in the index over time are important, which makes it possible to judge the general direction of price movement in the index basket, despite the fact that stock prices within the “index basket” can change in different directions. Depending on the principle underlying the choice of securities for the index, it can reflect the price dynamics of a group of securities, united by some criterion (for example, high, medium, small stock capitalization) of the selected market sector (for example, telecommunications), or the broader stock market in general.

A stock index is not single security, so one usually speaks of the “value” or “level” of the index, but not the “price”. At the same time, stock indices are often the basis of similarly named derivative financial instruments (index futures or options), which are used for investment and speculative purposes or for hedging risks. In this case, the value of the index is interpreted as the price of this instrument.

Mutual funds or funds, traded on the stock exchange, often use indices as a benchmark (a standard for copying).

According to Dow Jones & Co. Inc., at the end of 2003, there were 2,315 stock indices in the world.

At the end of the name of stock indices, there may be a number indicating the number of joint-stock companies on the basis of which the index is calculated: CAC 40, Nikkei 225, S&P 500.

History of stock indices

The first stock index was developed on July 3, 1884, in the United States by the journalist of the Wall Street Journal, a famous financier, founder of the Dow Jones & Company Charles Doe. The Dow Jones Transportation Average was calculated for the 11 largest transportation companies in the United States. Today it includes 20 shipping companies. However, the most famous is the Dow Jones Industrial Average (DJIA), calculated for the 30 largest industrial companies since 1928.

Methods for calculating stock indices

It is the sum of the prices of all assets included in the index, divided by the divisor. The most famous example is the Dow Jones Index:

  • The price of the ith share, D {\ display style D} DDDDDDD – Divisor of the Dow Jones index
    The divisor is changed to preserve the continuity of the index value when adding or excluding companies from the index, as well as during other corporate events (for example, a change in the number of shares of a given company included in the index). The divisor value is published in The Wall Street Journal, as of May 2014 is D = 0.15571591. This method is the easiest to calculate. Its disadvantage is that in it the weight of each share is proportional to its price, which is an arbitrary value. Currently, this method is used to calculate the traditional indices of the Dow Jones family, Nikkei 225. As a rule, modern indices do not use price weighting.

Stock indices trading

A stock index futures is a contract to buy or sell the par value of an index at a specified time in the future. In the US, there are futures on several stock indices: S&P 500 (Chicago stock exchange CME), NYSE Composite (New York stock exchange NYFE), MMI (Chicago stock exchange CBOT 1) [1].

Stock index futures trading began in the early 1980s. For individual investors, index futures have become a way to trade in anticipation of the future general movement of stock markets. Institutional investors have started using index futures to hedge portfolios and allocate assets.

Features of the index approach to investment

Individual investors are increasingly looking at strategies for investing in index products – exchange-traded funds (ETFs). ETFs have provided investors with an easy way to access virtually any market segment with a convenient low-cost investment package in which they can buy assets of all the largest companies in a given country or industry at once. Brokers and financial advisors also include index products in their asset allocation plans for clients.

Index funds, as the name suggests, track the market index (calculated based on the prices of a certain group of securities – the “index basket”) and charge a minimum fee. This is a clear formula that tells you which securities to invest in and in what specific proportions. Index funds are designed to provide minimal commissions and trading costs. The ETF structure follows the structure of the selected underlying index. The main disadvantage of using this approach to investing is market risk. During a possible fall in the market, the assets in the portfolio will also fall in value, and during an increase, they will rise. Due to the transparent structure of ETFs, the investor always knows the structure of his investments. No surprises – complete control.

It is important not to forget that historical returns and index growth do not guarantee future returns. However, in the long term, as a rule, there are positive dynamics of the index. The main rule that investors who invest in index funds should follow is not to panic during market downturns and not to sell assets that are falling in price, that is, to adhere to a disciplined approach.

Who is the index investing philosophy for?

The choice of an investment strategy primarily depends on the goals of each individual investor. Someone prefers to invest in the long term (for example, saving for retirement), while someone wants to save up for a large purchase (for example, real estate).

Long-term investing in indices is usually not only more profitable but also less risky for the investor. Thus, all investors can choose an index approach to investment and invest in exchange-traded funds (ETFs). The main thing is to correctly determine the investment goal and select a portfolio that is relevant to it, consisting of the set of assets that will allow you to achieve your individual goal in the desired time frame.

Let’s take an example from the well-known movie “Back to the Future”. Remember when Biff goes back in time, meets a youthful self, and gives away a sports almanac to predict match results? What if you were given an economic history book describing when all the world’s recessions hit? The fact is that possession of this knowledge and your further actions would not help you to “break the jackpot” in the stock market. The most valuable thing you could do is go back in time, open a brokerage account, put your money in there, and not let anyone touch it for 30 years. Keeping assets in an account for such a long period is much more profitable than knowing when the next recession will occur and trying to “beat” the market.

Therefore, choosing a long-term approach to investing in indices through exchange-traded funds seems to be optimal for both individual and institutional investors.

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