Definition of index

An index is an indicator of changes in the value of a basket of specific assets, which helps assess a particular market area. Indices are compiled by stock exchanges and analytical agencies. The assets are stocks, bonds, currencies, commodities, options, futures, and any other investment instruments listed on stock exchanges.

Indices use standardised metrics and methodologies to measure the changes in asset block prices. They are often used as landmarks for analysing and assessing the performance of an investment.

Main methods of calculating indices

  • Price Weighted: the index calculation takes into account the price of each asset in the basket: the more expensive the asset, the greater its weight
  • Capitalisation Weighted: the index calculation takes into account the market capitalisation of each company in the basket: the higher the capitalisation, the greater the weight of its shares
  • Equal Weighted: in calculating the index, all assets in its basket are given equal weight, regardless of price or market capitalisation.

Types of indices

  • Stock indices reflect changes in the stock prices of companies included in the index. For example, the Dow Jones Industrial Average (DJIA), S&P 500 (SPX), NASDAQ Composite (IXIC), or FTSE 100 (FTSE)
  • Bond indices demonstrate the dynamics of government or corporate securities, as well as those backed by mortgages or assets. For example, Bloomberg Barclays Aggregate Bond Index (AGG) or Merrill Lynch Domestic Master (IDM)
  • Commodity indices are used as a benchmark in the commodity market. Examples: S&P GSCI (GD) and Bloomberg Commodity Index (BCOM)
  • Currency indices reflect the value of the base asset against other currencies or a basket of currencies. Examples: US Dollar Index (USDX), Euro Currency Index (EURX), and British Pound Index (BPX)
  • Volatility indices estimate the future volatility of stock exchange indices. For example, CBOE Volatility Index (VIX)

How to use indices for trading

  • Estimating profitability. Investors analyse their portfolio by comparing its profitability to that of an index return
  • Assessing market conditions. Observations of an index can provide direction for investors to search for the right assets
  • Determining trends. By tracking the behaviour of indices, investors can notice market patterns, which will lead them to change the assets and their amount in their portfolios depending on the market sentiment
  • Forecasting market behaviour. Analysis of index dynamics can provide additional information about probable market movements to find the best entry point if an investment idea has already been identified

Disadvantages of investing in indices

  • Unequal assets. The calculation of an index involves a wide range of assets that differ in many characteristics, including the value
  • Limited return. Investing in indices can substantially reduce the likelihood of significant returns, as index fluctuations are based on the overall performance of a large basket of assets
  • Low level of diversification. Stock indices can include a large number of companies from the same sector.