What is index trading and how does it work?

Many new investors who start investing on their own start with index trading. This simple and generally inexpensive way of investing helps to put together a diversified portfolio. Index trading is a form of investing in which you follow the market (passive investing) instead of trying to beat it (active investing).

What is index trading?

A stock index is the weighted average of a number of selected shares that meet certain criteria. A Dutch example is the AEX index. This index consists of the 25 largest and most traded listed companies on the Euronext Amsterdam. This is not the only index that is linked to this exchange. Medium-sized companies (so called mid-cap) have been represented in the AMX (Amsterdam mid-cap index) since 1995. Since 2005, a third index has been added, called the AScX (Amsterdam Small cap Index). This consists of 25 small cap companies listed on the Euronext Amsterdam. Many countries have their own index. There are also indices with companies from a larger area. Popular indices are for example:

EURO STOXX 50

This stock index is based on the fifty largest publicly traded companies in Europe. It looks at the number of tradable shares (the free float) per company to determine the size. In addition, a company is allowed to occupy a maximum of 10% of the index.

S&P 500

The S&P 500 is the stock index most followed by investors worldwide because it paints a reliable picture of the US stock market. American companies that are listed on the New York Stock Exchange (NYSE) or the NASDAQ and meet certain criteria can be included in this index.

NASDAQ Composite

Since the creation of the stock market the NASDAQ (National Association of Securities Dealers Automated Quotations) in 1971, the NASDAQ Composite index has also existed. This index is larger than the previously mentioned indices as it consists of all companies listed on the NASDAQ. These are mainly companies in the technology sector.

Dow Jones Industrial Average

The Dow Jones Industrial Average (DJIA), is also known as the 'Dow 30'. This index is based on thirty large, public blue-chip companies listed on the New York Stock Exchange (NYSE) and the NASDAQ. It is the second oldest US index after the Dow Jones Transportation Average. The DJIA is designed as a measure of the health of the US economy.

MSCI World

The MSCI World Index includes large- and mid-cap companies from 23 countries and 26 emerging markets. The index is designed to track global equity markets and is managed by Morgan Stanley Capital International. That's also where the acronym MSCI comes from.

Index trading via ETFs

It is possible to invest in an index through an index tracker. A tracker is formally known as an exchange-traded fund, or ETF for short. It is a product that tracks an index, commodity, bond or a composition of products. The goal of an ETF is that the performance of the product is as close as possible to the value of the underlying products. The main benefit is the ability to diversify your investment portfolio with ease and at relatively low cost. An ETF is similar in design to an investment fund. An investment fund is a portfolio managed by experts consisting of various financial products. This can be an equity fund, but also an index fund. A major difference between an ETF and an investment fund is that an investment fund is often actively invested (many purchases and sales), making the product more expensive than an ETF. In general, ETFs qualify as passive investing.

On this page you can read more about buying ETFs through our platform.

Index trading through options and futures

In addition to investing with an index tracker, it is also possible to invest in an index using an option or future. A future is a forward contract to deliver an underlying product at an agreed price at an agreed time in the future. That underlying product can be an index. Index futures are always settled in cash. A contract size of 200 x the index applies.

When you buy an option, you buy the right to buy or sell a certain number of securities in the future at a certain price. In the financial world, options and futures are derivatives. This means that they are derivatives, which derive their value from the price of an underlying asset. With options, the underlying product can also be an index. The value of an option is mainly based on the price of this underlying asset, the volatility of the underlying asset and the term of the option contract.

Before you start investing in options or futures, it is important that you first learn what the possibilities are, but much more important, that you understand the risks. Options and futures, like other complex products, are not suitable for novice investors.

What is the risk of index trading?

Index trading can be beneficial, but it is not without risk. At DEGIRO, we are open and transparent about the risks involved in investing. With index trading, you are still investing over a total index through a single transaction. Because with index trading you follow the market, you run the risk of not being able to anticipate changes, such as the takeover of a company or a change in the composition of the index. Although indices are based on multiple companies, so that element is diversified, the timing of your investment can also have a significant impact on your return. Rather than investing an amount at once, which exposes you to the cost of your securities at one point, you can choose to invest gradually over a longer period of time. By investing in smaller amounts, such as on a monthly or quarterly basis, you are less exposed to the price paid at the time of investment, but the price of the investment is averaged over a longer period of time. This method is called average unit cost. Read more about diversification.

Before you begin investing, there are a number of factors important to consider. It helps to determine how much risk you are willing to take and which products are best for you. In addition, it is not advisable to invest money that you may need in the short term, or to take positions that may cause financial difficulties.

Investing with DEGIRO

Are you interested in index trading through DEGIRO? To invest in financial products, such as ETFs, options and futures, you need a broker to place an order. DEGIRO is an online broker that considers it important that you can hold a diversified portfolio with low costs.

We offer a wide range of options in addition to the list of ETFs to invest on over fifty exchanges in thirty countries, with some of the lowest fees in the market. For more information, visit the markets page on our website. In addition, check out the transaction fees on our fees page.

The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Please be aware that facts may have changed since the article was originally written. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.