Smart things to know about index trading

If you are familiar with investing in the share markets, you must often hear things like “the market has risen” or “it has fallen”. However, when you compare this rise or fall with your portfolio, you do not see any considerable change. Then how did the market rise or fall; what does "market" mean in this scenario? Here, the word ‘market’ means the value of the ‘index.’

What is index trading?

An index is a collection of stocks of various companies which are grouped to get a general idea of how the sector or industry is doing. The stocks of businesses which are the main contributors to that particular sector in an economy are combined to form an index. If the index is doing well, it means that the sector is bullish or the prices of stocks have risen. If the value of an index has fallen, you can believe that the market is bearish or that the prices of stocks have fallen.

There are two main indices in the Indian market:

• S&P BSE Sensex: It is an index of the Bombay Stock Exchange (BSE). It is a collection of 30 well-established and financially sound companies.
• CNX NIFTY: It is an index of the National Stock Exchange (NSE). It includes the top-50 companies influencing the market trend in the economy.

Before you start index trading, here are some smart things you should know:

1. Method of index construction

   To be able to trade in an index smartly, you should be able to understand how an index is constructed. For a company to be included in an index, it should meet certain criteria and should consistently maintain the said criteria, or it would be replaced by another stock with a better potential.

   Once included in a particular index, the company is given a certain weightage. This weightage defines a company’s ability to regulate the index by that percentage. For example, if a company has a weightage of 8% in NIFTY50, it means that it can influence the index's price by 8%.

   Weightage is assigned by a method called free-float market capitalization. It is the product of the stock’s price and the total number of its outstanding shares the market; larger the market capitalization of a company, higher the weightage.

2. Index trading vs share trading

   Trading in indices gives you exposure to the companies that are included in the index. For example, if you are trading in the S&P BSE index, you may invest in any of the 30 companies entered in the index.

   On the other hand, share trading allows you to only invest in the shares of a single company without being exposed to the stocks of other companies trading in the market.

   This added benefit of investing in stocks of different companies by purchasing only one investment is the main reason why index trading is considered a perfect tool for diversifying the investment portfolio of an investor.

3. Risk factor

   Index trading can be highly risky when compared to other modes of investing. As it contains the stocks of the biggest companies in the whole market, it makes it highly speculative and volatile. A slight price fluctuation in the stock price of any of the company can negatively affect the overall market trend, tanking the share prices of other companies also.

   Apart from the risk factor about the price fluctuation, index trading requires an enormous amount of money to invest as you are investing in the some of the biggest companies. It makes index trading even riskier as there is a possibility of huge loss because of the significant amount invested.

   If you are not sure about the market trends and its contributing factors and want to avoid this huge quantum of risk, consulting a broker from a good brokerage firm and asking for his/her valuable advice would go a long way in protecting yourself from losing your money during index trading.

4. Factors affecting valuation of indices

Trading in indices still requires an investor to understand how they are valued in the market. A basic understanding of the valuation and about the factors that influence the valuation of an index is a prerequisite of being a smart investor. Some of the factors affecting the values of the stocks of an index are:

• Fundamentals such as GDP and inflation rate
• Changes in key interest rates and monetary policies by the banks and other parent regulators of the market
• Geopolitical factors like the demonetization policy
• Internal factors regulating the internal business conditions of the companies, like the appointment of a new CEO or launching of a new product.

Through 5Paisa.com, you can open an online trading account in less than five minutes and can become a day trader in less than a day. As our experienced brokers will provide you with valuable advice and profitable strategies to start trading in indexes and cut your losses.