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Home » FAQ » How Does Equity Indices Trading Work?

How Does Equity Indices Trading Work?

During any trading day, stock prices of specific companies will go up or down. Since a stock index is a compilation of a basket of underlying stocks, its actual price will move up or down based on the overall dynamics (mathematical and statistical formula) of which each stock price contributes to its final price.

The following are useful points to understand when trading equity indices:

  • 1. All the stocks in a specific equity index (e.g. Dow Jones) are subject to a selection process and might be substituted by another company if their overall trading performance is overcome from a newcomer. In other words, the companies that belong to a basket are not guaranteed to be always the same.
  • 2. The determination of the influence of a specific stock to the overall stock index includes calculations and rules. Not all stocks that add up to the basket are treated as equal. In simple words, the overall price of stock index is not a simple addition of the prices of the stocks and a division by the number of stocks.
  • 3. A stock index shows the general consensus and can be considered a benchmark of performance of the overall stock market with historical value.
  • 4. As mentioned in point 2, since not all stocks that belong to the basket are treated as equal, more weight is given to the index from companies with larger capitalization. This means that if the stock of a specific large company falls for any reason, the overall index will follow it even though the rest of the stocks in the basket might not be falling.
  • 5. As mentioned in point 1, the underlying stocks that belong to the basket, which is called an index, change over time. Over a historical period, the index itself does not always represent the same basket of stocks.

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