Index Trading or Forex Trading?

Forex trading

Forex trading, also referred to as foreign exchange trading or FX trading, is the conversion of the currency of one country into another country’s currency.

FX trading is executed in the forex market, a decentralised over the counter market (OTC). It is the most liquid and largest financial market in the world, with an average daily trading volume of more than $6 trillion.

Index trading

Generally, an index measures the performance of something, and in finance, it is a method to measure the performance of a basket of securities, such as stocks, in a standardised way. Put in other words, and index typically refers to a statistical measure of change in a securities market.

Indices, also referred to as indexes, are utilized as instruments to describe a specific financial market, to compare the return on specific investments, and as benchmarks to assess an investment’s performance against.

Index trading is a way used by traders to speculate on price movements in indices. It is a method by which traders aim to gain profits from the price movements of indices.

The essential criteria of an index are its potential as an investment instrument and its transparency regarding how it has been put together.

Essentially, index trading means that you will be trading on what is called a ‘basket of securities’, such as a ‘basket of stocks’ or a combination thereof. The benefit is that you do not even have to buy the stocks to be able to trade them.

There are various types of indices available for trading, like:

• A commodities index is an index that tracks the price and return on investment of a basket of commodities. The value of the index rises and falls according to its underlying commodities.
• A bond index, also known as the bond market index, is made up of the prices of selected bonds.
• A stock index represents the value of a group of stocks (shares) from a given stock exchange.

For the purpose of this article, the focus will be on stock indices.

Stock indices

A stock index itself does not have any intrinsic value, instead, it reflects the stock prices of all its underlying assets.

Stock indices have a diversity of variables. The number of stocks can differ considerably from index to index, from a few companies to thousands. The price of an index is determined by way of price weighting. Indices based on price weighting are based on the average price of all the stocks of which the particular index comprise of. Some stock indices will give equal weight to all the stocks they accommodate, though some will give more prominence to larger stocks.

A stock index is a great way to evaluate a particular stock market, although, it also enables investors to determine the performance of their individual portfolios in order to adjust specific underperforming investments to be more in line with the general trend of the specific stock market.

A stock index represents the value of a certain combination of stocks of a particular stock market. If the value of the specific stock index increases or decreases, it is an indication of the overall performance of all the stocks within that specific stock index. For instance, when the average price of all the stocks included goes up, then the overall value of the stock index increases too. Vice versa, the same principle applies when the average stock price falls.

However, the up or down direction of a stock index is not a sign that the prices of all the individual stocks are moving up or down. For instance, the JSE Top 40 may increase in value, and while some stocks are going up, others could be moving down.

Every stock exchange in the world has a benchmark stock index, and some have several indices. It would be almost impossible to track the performance of every stock in every market or country. Therefore, stock indices are valuable instruments for traders and investors to measure the overall performance of a stock market or a country’s economy.

Some well-known and most heavily traded stock indices

Nowadays, there are hundreds of stock indices worldwide. Some of the most popular stock indices are:

• The Dow Jones Industrial Average (DJIA) – One of the oldest and best-known stock indices in the world. Comprises 30 large, publicly-owned US companies. Also known as the US30 or simply referred to as ‘Wall Street’.
• The FTSE 100 – The Financial Times-Stock Exchange (FTSE) represents the 100 biggest companies on the London Stock Exchange (LSE) by market capitalisation, i. e. roughly about 80% of the LSE’s market capitalisation. It is sometimes called the ‘UK 100’, while the slang word for it is ‘Footsie’.
• The DAX – Referred to as the ‘Germany 30’, includes 30 major Germany companies trading on the Frankfurt Stock Exchange.
• S&P 500 – Comprising the 500 largest US stocks, representing about 80% of total US market capitalisation.
• Nikkei 225 – A basket of 225 of Japan’s biggest companies from the Tokyo Stock Exchange, including Toyota and Panasonic.
• Hang Seng – Tracks the performance of the 50 largest companies by market capitalisation on the Hong Kong Stock Exchange.

In South Africa, the Johannesburg Stock Exchange (JSE) has, inter alia, the following indexes:

• The JSE Top 40 – A basket of the top 40 listed companies on the JSE based on market capitalisation.
• The JSE All Share Index (ALSI) – An index consisting of the largest 164 listed companies on the exchange, representative of almost 100% of the market capitalisation.

Trading stock indices versus trading individual stocks

Here are some advantages of trading stock indices as an alternative to stock trading:

• Investing in a stock index implies your investment is diversified, representing a multitude of stocks. Contrarily, when investing in stocks you are exposed to risks that companies may encounter.
• Stock indices can allow you to diversify, not only sectorally, but investing in a variety of different companies, providing more opportunities.
• With a stock index you trade on the movement of a stock market as a whole, in contrast to the price movement of only one or a few stocks.

How do I trade stock indices?

Stock index trading enables traders and investors to trade or speculate on the price movements of stock indices without having to buy individual or numerous stocks.

Stock indices are popular trading instruments. However, they cannot be traded directly. Instead, traders of indices utilize other financial instruments such as tracker funds (also known as index funds) and derivatives like contracts for difference (CFDs), futures and options, to trade and speculate on the movements of various stock indices.

Keep in mind, no matter what you trade: knowledge is power. There is a wealth of information available on the websites of authorised index traders to acquaint yourself with before you start trading indices.

And a word of caution – when making use of a broker for trading indices in South Africa, make sure he or she is approved by the Financial Sector Conduct Authority (FSCA).

Stock index trading versus forex trading

When comparing the two trading methods, keep in mind that the most suitable one for you will depend on factors, among others, such as your trading strategy, your level of knowledge, your understanding of the particular market, and your risk tolerance.

The following are some of the differences between stock index trading and forex trading:

• Some stock indices are less liquid than the forex market.
• Forex trading requires you to predict the movements of a single currency pair, which can be affected by numerous factors, and can be highly volatile. Conversely, with index trading your trading is based on predictions about the broad movements of a particular stock market.
• Index trading, specifically on indices with wider spreads, may be more suited to long-term traders. On the other hand, forex trading is normally more suitable for short-term traders who prefer to profit from small price changes and who are not averse to high volatility and low spreads.