How to Trade Indices UK – Beginner’s Guide
In this guide, we explain the essentials of how to invest in indices and why they are a highly convenient way of gaining fast and cheap exposure to a large basket of companies.
In addition, we show how they can be used to target particular regions to take advantage of the unique makeup of each stock exchange.
Finally, we review some popular indices trading platforms based on important features such as fees and account types.
What are Indices?
A stock index is comprised of a collection of publicly-traded companies that adds together their values and expresses it in terms of an index number beginning at a base year. By way of an example, the FTSE 100 was launched on 3 January 1984 with a starting value of 1,000
Major stock indices such as the FTSE 100, FTSE 250, the Hang Seng Index and the S&P 500 began life as a way of enabling investors to make better comparisons between stocks and also between different stock markets.
It has not always been the case, but today retail investors to gain exposure to the value of a stock index and to benefit from the direction in which it may be moving, either higher or lower.
Who creates indices and what’s their methodology?
Indices were often created by data providers and rating agencies, which is why they have names such as FTSE, where the FT stands for Financial Times, and S&P 500, where the S&P stands for Stand & Poor’s the rating agency.
The indices have strict methodologies and rules governing how constituent companies are included for entry and when they are ejected. So for example the FTSE 100 includes the 100 largest publicly traded companies on the UK London Stock Exchange and the S&P 500 the 500 largest publicly traded companies on the New York Stock Exchange.
However, there are other rules that companies have to comply with other than their size by market capitalisation, such as liquidity and the period of time that they have traded at the required size. On that last point, for example, there is no point including a stock one quarter only to discovery by the next it has fallen in value to such an extent that it is no longer meets the market cap threshold.
However, not all indices are market cap-weighted. The DJIA is price-weighted, meaning the constituents are selected based on their share price. The FTSE 100 and the German DAX Index 30 are examples of market cap-weighted indices.
Types of Indices Trading and Investing
There are a number of ways to gain exposure to indices, depending on which financial instruments you are most comfortable with and the amount of risk you wish to take.
Index funds can be either mutual funds or include some exchange-traded funds. In their mutual fund guise, they are collective investment vehicles in which the funds of investors are pooled to invest in all the companies that make up an index.
These types of mutual funds were known as trackers but are more commonly referred to these days as index funds. They are not confined only to stock indices, but in this guide, we are concentrating on stocks.
A mutual fund will track the stock index by either directly buying each company stock that comprises the index of, if the stock index contains an excessively large number of constituents such as the US stocks small-cap indices the Russell 2000 or Russell 3000, it may sample the index instead. In such circumstances the mutual fund will buy a sample of the stocks that. have been proven historically to mirror the overall performance of the index.
Index funds typically charge fees to investors in the region of 0.25% to 0.85%. That might not seem like much – and they are certainly a lot less than you would expect to pay for an actively managed mutual fund – but nevertheless they can eat into returns because of the effect of compounding. US investment group Vanguard has made a name for its self as a pioneer of index funds and provides some of the cheapest and most popular products in the index funds area.
Index funds of the mutual funds’ sort, issue new units when investors buy into a fund. They do not trade on the stock market in the same way that you would buy shares. Instead, they are priced just once a day. When you want to exit a mutual fund investment you will need to redeem your units, which means the fund manager destroys your units and returns cash to the investor to the value of the units owned.
Exchange traded funds
Exchange traded funds are similar to mutual fund trackers in that they track the price of an underlying asset or basket of assets, often represented in an index, but unlike mutual fund index trackers, an ETF trades on the stock market like normal shares – so they have a share price that moves constantly in real-time in relation to supply and demand the stock from buyers and sellers.
ETFs have grown enormously in popularity with retail investors because they are a cheap and flexible way to access stock indices in addition to a vast array of other asset classes and previously hard-to-access niches of the financial universe.
ETFs are even cheaper than index funds, with fees are in the range of around 3% to 4.5%.
Contracts for Differences
Contracts for differences (CFDs) are derivatives products created by a financial institution in which parties to a contract agree to pay the difference between the price when the trade is opened and the price at closure.
These derivatives products, and the CFD brokers that provide them, are popular with UK investors and there are a number of brokers that specialises in them. They can be used to gain exposure to all sorts of financial asset classes, not just stock indices.
They are at higher risk than say an ETF or mutual fund because of the way they are constructed, which means it expensive to hold them for long periods of time because of overnight fees charged by the issuer to keep positions open for the contract holder.
However, as a way of gaining exposure to a stock index they can be used for day trading purposes – see more on this below in the indices trading strategies section. CFDs allow you to both buy and sell an index. That’s to say if the price goes up you benefit, but you can also go short by executing a sell trade, so if the index falls in value you benefit.
Options and futures
An options contract gives the owner the right but not the obligation to buy an asset at a certain price. These derivatives products were once they were the preserve of professional and institutional traders, they have now gone much more mainstream, especially in the US.
To trade options in the UK, you are likely to have to answer correctly a questionnaire to show that you understand how they work and the risks involved. Futures are similar to options except that instead, they are being a right but not an obligation to buy or sell the asset, with futures the contract holder is required to take delivery of the product (unless it is cash-settled) unless the contract has been closed before expiry. Options are the more popular of the two, so let’s look at how options work.
There are two types of options contracts – a call or a put. If you expect the price of a stock to rise you would buy a call option and the opposite for a put.
What is In The Money (ITM, Out of The Money (OTM) and At The Money (ATM)?
A call option has an expiry date and a strike price that represents the price the buyer can sell the contract for upon expiry.
If the price has risen above the strike price then the call option is said to be In The Money (ITM) and if it has not moved above the strike price then it is Out Of the Money (OTM) and worthless. If the contract strike price is equal to the spot price, the contract is said to be At The Money (ATM).
An option usually comes in lots of 100, so a single contract can give you the right to buy or sell 100 shares of stock. This means even small movements in the price of the stock or index are magnified enormously for the owner of the option. Add to that the ability to trade on leverage (using borrow money to magnify the trading position) and the size of gains for a relatively small outlay can be very large, but so too can the losses.
Trading on margin can expose the trader to a margin call, where you have to deposit more funds with the brokerage to cover possible losses if a position moves against you.
Spread betting is another way to get into trading on indices. With this instrument, a trader bets a certain amount per point of movement in the underlying index. As with options and CFDs (and certain so-called inverse ETFs and index funds – see more in the strategy section), you can go short.
Spread betting is arguably even riskier than options or CFDs. A small amount per point can escalate if the index runs into a bout of volatility. The index might fall 200 points – if you have bet £5 per point, then your position would be £1,000 in the red. You can limit risk by using stop-losses. See more on stop-losses below.
One of the advantages of spread betting, however, is there is no capital gains tax on your returns.
The chief advantage of trading indices is the exposure to an entire index that can be achieved depending on which instrument you decide to use.
Imagine how much it would cost in transaction fees to buy every single stock in the FTSE 100. Instead of doing that you can with one click ‘buy the index’ when you take the index trading approach.
Depending on the particular index, it will provide the investor with immediate exposure to a diversified basket of stocks, which is a key way of minimising risk in an investment portfolio. Because the index will have companies operating across the entire range of sectors, you gain exposure to stocks that can be relatively uncorrelated, meaning when one goes down another may go up because of the different attributes of the economic sectors and industries they operate in.
Risks of Indices Trading
Low-risk as a long-term investment
Investing in an index and leaving it alone as part of a long-term investment strategy is sometimes a low-risk approach.
Short-term trading is riskier
However, trading is different from medium and long-term investing and takes place typically over a short duration. Because of this short-term investment risk can be higher, especially if you are not able to hold your position open until it moves into a profitable position, or you are unable to meet a margin call, or your position does not have a stop loss and an index drops precipitously, exposing you to large losses.
Again, the calibration of the risks involved will in part depend on which instrument you decide to trade indices with.
Lots of moving parts: weighting, regions and macro environment
An index can go up or down for a variety of reasons and in some ways can be more difficult to make a correct call on than individual stocks.
Each index has unique characteristics. For example, if you want to invest in S&P 500, it has lots of tech stocks (weighting of 28%), while if you were to invest in the FTSE 100 has very few (weighting of just 1.2%). The FTSE 100 includes lots of multinational companies that earn most of their revenues in dollars, which means when the pound falls against the dollar, the value of investments of the UK-resident investor in the FTSE 100 index will rise (the index will have gone up).
Because stock indices are country-specific, the macro environment prevailing in the country (and globally) will be reflected in the returns from the index – for example, a rise in unemployment or inflation might lead index investors to sell.
What Indices Can You Trade in the UK?
Below is a list of the major stock indices in alphabetical order that can be traded in the UK. Most trading venues will follow the short name style. The FTSE 100 is normally simply displayed as ‘UK 100’ and Dow Jones Industrial Average simply as ‘Wall Street’ which is worth noting if you are looking at how to invest in Dow Jones UK.
|Short name||Full name|
|Australia 200||S&P/ASX 200|
|China A50||FTSE China A50|
|EU Stocks 50||EURO STOXX 50|
|France 40||CAC 40|
|Germany 30||DAX 30|
|Hong Kong 50||Hang Seng China 50|
|Italy 40||FTSE MIB|
|Japan 225||Nikkei 225|
|Netherlands 25||AEX 25|
|Spain 35||IBEX 35|
|Switzerland 20||SMI 20|
|UK 100||FTSE 100 – known colloquially as ‘the Footsie’|
|US Small Cap 2000||Russell 2000|
|US SP 500||S&P 500|
|US Tech 100||NASDAQ 100|
|Wall Street||Dow Jones Industrial Average (DJIA, Dow 30) – known colloquially as ‘the Dow’|
Indices Trading Platforms
Now we’ve shown you how to invest in indices, let’s review some popular trading platforms that offer access to indices.
How to Trade Indices Today
Now we will examine how to buy indices on a broker of your choice.
1. Trade the NASDAQ 100
We are going to trade the NSDQ100 by opening a ‘buy’ position. Click on the ‘NSDQ100’ market in the list of indices markets. This brings you to the instrument page where you will find further information on the NASDAQ index market under ‘feed’, ‘stats’, and ‘chart’. The feed provides a view of the posts made by fellow users, which you can like, comment on or share.
2. Set an amount to trade, stop loss and take profit
On the trading ticket there is a ‘trade’ drop down which you can change to ‘order’ if you want to set a ‘limit’ order. That means instead of taking the market price as shown in the default screen, you can decide at what price you want to trade.
Units need a bit of explanation. This is basically the size of the position you are taking. In the screenshot, it shows the amount ($50), but below it in grey, note the equivalent units is 0.29. Also to the right of the amount entry there is a ‘units’ button that if clicked on will show the unit equivalent instead of the dollar amount of the trade.
What is unit size and how is it calculated?
Unit size for indices is usually calculated using the following formula:
Amount invested x leverage/rate when positioned opened
So in the example above:
200 x 20 (= 4,000) / 13848 = 0.2888 (rounded up to 0.29)
Exposure is clearly shown and the amount of total equity committed to the trade. Also at the bottom of the ticket, the overnight fees are often stated also.
3. Go to the portfolio page to see your executed order
To see your trade, go to the portfolio page, where all your holdings are listed.
Click on the settings cog icon and it brings up a drop-down menu, where you can select to open a new trade, write a new post, view chart, and set a price alert for the NSDQ100.
Staying with the portfolio view, the down arrow on the extreme right of the horizontal menu (see screenshots below) brings up the option to switch to ‘manual trades view‘. This is useful for editing trades all in one place, such as if you wanted to close more than one position:
Clicking on the cog icon in the manual trades view brings up different features, namely the trade ticket, where you can directly edit your trade by adjusting the stop loss and take profit positions:
How to Trade Indices UK – Conclusion
In summary, indices trading is available from a wider cross-section of investment platforms in the UK, but for beginners, trading features and regulations are of paramount importance.