Equity prices fluctuate by the minute and can be volatile especially around earnings season. This is a period when companies release their financial results to the public. The movements of individual stocks during this period, can surge or plunge based on several factors including earnings, as well as guidance. Additionally, stocks in a specific sector are subject to change based on the financial results of competitors. One way to avoid exposure to an individual company, but still gaining exposure to the equity markets is to buy and sell equity indices.
What is an Equity Index?
An equity index is a grouping of stocks that are put together for a specific reason. For example, the Dow Jones Industrial Average which tracks 30 large, publicly-owned companies that are actively traded on the New York Stock Exchange and the NASDAQ, reflects visible high priced stocks. Stocks with higher share prices are given greater weight in the index. The index reflects the sum of the price of one share of a stock for all the components in the index, divided by the Dow divisor.
The most widely followed equity index, is the US S&P 500 index, which is a broad-based index of large cap US stocks. You can actively trade the S&P 500 index. The calculation of this index differs from the Dow Industrial Average in that it is a market capitalization weighed. Instead of basically taking the price of the highest stocks and dividing by the divisor, the index uses market cap to weight the average.
What Kind of Equity Indices are Available?
There are several kinds of indices available. Most of the indices that are traded reflect the movements of the largest and most recognizable stock markets from given countries. For example, the DAX in Germany, the FTSE in the United Kingdom and the Nikkei in Japan. In addition to indices that reflect the equity markets in specific countries, there are also indices that cover specific sectors.
What is a Sectors Index?
A sector index is an index that reflects the prices of specific industries. This includes some of the more popular sectors such as the energy sector, the industrial sector and the financial sector. In addition, there are sector indices that follow the utilities space, the communications sector and the technology industry.
How do You Trade Sector Indices?
One of the most popular ways to trade sector indices is through sector exchange traded funds (ETFs). An exchange traded fund is a trust that holds other assets. Sectors ETFs are stock like products that hold shares of companies that are in a specific sector. For example, the XLF (financial sector ETF) holds shares in large financial companies such as JP Morgan Chase and Berkshire Hathaway. You can buy and sell sector ETFs which will provide you with exposure to specific industries.
Summary
The benefits of trading indices relative to individual stocks is that you remove some of the volatility associated with holding shares in an individual company. Each index can be calculated differently. If you want to trade a specific sector as opposed to a broad-based index, you can trade sector ETFs which provide exposure to a certain industry.