What are the differences between trading indices and stocks?
In many respects, trading stocks and trading indices are very similar. The trader wants to buy the stock or the index for a low price and later sell it for a higher one.
While the basic profit principle is the same, there are a few differences between trading stocks and indices of which market participants should be aware. This article will explain them.
What are stocks and indices?
Stocks are financial instruments that represent fractionalized ownership of a corporation. If an investor owns 1% of a company’s stock, they own 1% of the company. Companies issue stocks to raise funds to run their business operations. Stocks are sometimes known as equities and entitle their holder to a share of the issuing company’s profits.
Indices group individual stocks together. Examples of indices include the S&P 500 and the FTSE 100. The former index tracks the prices of the 500 top-performing companies in the United States.
The three most widely followed indexes in the U.S. are the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite.
The latter tracks the prices of the 100 top-performing companies listed on the London Stock Exchange.
Indices like those mentioned are known as benchmark indices and include company stocks that are performing well based on predefined criteria. Other types might focus on a specific market sector, such as tech or health care, or they might include companies based on their market capitalizations.
Stocks trade on stock markets like the London or New York Stock Exchange. Meanwhile, indices trade at brokerages, such as easymarkets.com. Individual stocks often trade on broker platforms, too. The difference between the two trading venues is that asset prices come from an exchange and a brokerage simply references these prices.
Trading stocks and trading indices: What’s the difference?
Beyond where price discovery occurs, there are other key differences between stocks and indices of which traders should be aware. The main one is relative volatility.
When investing in an individual stock, the fortunes of that single company determine the price. If the company announcesmassive, unexpected earnings over a quarter, you can expect to see the stock price rise dramatically. Conversely, if something negative happens to the company, you will often see a sharp decline in the stock price.
Since an index comprises many different stocks, volatility is less extreme. Suppose one company in the S&P500 sees a sudden 50% drop in its stock price. The index will not fall by 50 percent because its price is an average of 500 company stocks. While this reduced volatility protects traders from sudden price drops, it also means the potential upside is limited.
Reduced volatility also means that an index trader does not need to monitor their positions as closely as a stock trader. Markets usually trend in a direction and providing the trend is upward, an index price should also increase.
Diversification is a less involved process, too. A stock trader will have to select the stocks to which they want exposure whereas an index is already formed, requiring less research on the trader’s behalf.