Gaining Index-based Insight

Dec 16, 2022

A stock index acts as a sort of microcosm for an economy, market, or a particular sector, making it as easy to track a broad scope of securities as it would be to track a single stock. When an index falls, it means that the average price for the stocks included in the index has dropped. Some stocks in the index may grow even as the index declines, but it still signals a stronger general downward trend among the tracked stocks.

When working with the stock market, it is important to keep tabs on inflation, which constitutes an important task for any investor. Inflation level determines the various rates that influence the economy as well as, ultimately, the bond market’s yields. Price stability, however, does not mean zero inflation, but is more about having a predictably low rate of price growth that only fluctuates within a narrow corridor. The difference between a forecast and the growth target indicates to what extent the regulator should adjust its monetary policy. As a result, the inflation target is typically a set value, currently residing at the 4% mark. All further actions taken by monetary authorities to regulate interest rates are aimed at achieving this target.

Another type of stock indices are bond indices. Keeping track of major bond indices is useful as they help keep a finger on the pulse at all times and quickly assess the performance of the entire market or its individual segments with a single indicator, instead of tracking the dynamics of numerous bond-related issues. The best benchmark for measuring your investments’ performance is the total return indices. Unlike price indices, total return indices take all the investor’s returns into account.

Tracking the market via stock indices

Luck factor is practically eliminated in the stock market, but stock quotes can be affected by an ongoing situation in a certain industry or by geopolitical events. These changes do not happen by chance, even if it is impossible to take all factors that could influence the share price of a particular company into account. The main point is to be as informed as possible, study the market to make predictions, then formulate or update a successful model or strategy.

When planning to buy securities of any company, it is necessary to at least study its competitors by comparing the target company’s indicators against theirs. It may be a minor company with great prospects. For example, to grow twofold, a large company needs to make a huge effort, while its smaller competitor would only need to open a new branch in another city.

Relying on just one company and its securities is a lost cause. Unless you plan on going bankrupt, keeping “all eggs in one basket” is not an option. That’s why a good investor needs to be able to put together a decent investment portfolio. Some securities can drop in price or rise in value, in which case you will need to rebalance by buying more or selling some of the previously acquired securities.

What to pay attention to when working with securities?

Investors keep an eye on economic prospects and earnings posted by major companies via the S&P500, or “the barometer of the U.S. economy.” Its decline is a signal of deterioration in financial markets and the overall economic situation.

Аnother interesting stock index that is directly related to the S&P 500 is the volatility index VIX or, as it is also known, the Fear Index, which reflects traders’ expectations of the S&P 500 broad market index for the next 30 days or, more precisely, its implied volatility. The indicator is calculated based on the bid and ask quotes for the index option contracts.

The S&P 500 and VIX have an inverse correlation: whenever the market is falling, the volatility index is rising, and when the market is growing, the volatility index declines. The basic theory is that, if the VIX is above 40-45 — it indicates a panic in the market and that investors are fleeing risky assets. If the VIX value falls to 20 or goes even lower, the markets obviously see a rising trend.

Insight gathered from working with stock indices:

  • A view of the general market situation. By looking at a single index value, an investor can immediately understand the general market trend, whether there are more buyers or sellers in the market, if the stock prices and bond yields are going up or down, and so on.
  • Understanding the current economic cycle. How investors behave in stocks, bonds, and currencies largely illustrates the general state of the economy and their future expectations.
  • Identifying the most promising and growing industries and market segments. Thanks to industry indices, you can understand which industries feel the best now or will be the beneficiaries of growth in the nearest or somewhat distant future.
  • Evaluating the results of their investments. To understand how successful an investment has been, investors often compare their results to an index. The main goal for most investors is to earn a return at least in line with the index, but, if passive players invest in index funds for this purpose, then active investors, on the contrary, try to outplay the market. In practice, however, not many investors find relative success.

Stock market index applications

Stock market indices are useful for several key reasons:

  • Tracking popular stock market indices can give you an overview of the stock market as a whole;
  • Tracking lesser-known indices can help you see how a particular market segment is performing compared to the market at large;
  • If you don’t want to invest in individual stocks but simply want to match the general market performance, a cost-effective way to generate solid returns over time is to invest in index funds that track the stock market indices you use.

Stock market indices offer simple investment opportunities that even novice investors can use to participate in the long-term success of the stock market. They help facilitate the understanding of how the market works without having to follow the ups and downs of each individual stock.

How to make money on stock market indices?

Indices cannot, in fact, be bought or sold like, for example, stocks. But one can make money on them, using certain derivative financial instruments:

  • Index futures. When you buy or sell an index future, you are conditionally buying or selling shares issued by a group of companies included in the index. This tool is often used by investors to diversify risks;
  • Index CFDs, a more affordable option for traders. CFDs can be traded using leverage. Thus, even with small investments, you will have access to the stock market. Another advantage of CFDs is that they are available in the classic MetaTrader 4 and MT5 trading terminals.