The implications of index trading
Something came up recently in one of the forums I visit from time to time. It had to do with indices and the implications of trading them in terms of their component stocks. I’m sure others have similar questions, so I thought I’d tackle the subject here.
Firstly, it is worth taking a look at what an index is. There are so many of them and they are the first thing many folks think of when considering the stock market (and others as well). A stock index is nothing more than a mathematical construct which is used to track the change in value of a collection of component stocks. For example, the Dow Jones Industrial Average (DJIA) comprises 30 stocks that have been chosen to be representative of the health of the US industrial complex. When the price of a stock in the DJIA index changes, the index changes.
Now it is worth considering that indices were created at a time when the only way to trade them was to actually buy all of the stocks which are included. With the advent of a number of new financial instruments, though, one can now actually trade an index without doing transactions in the underlying shares. That can be done through futures, options, and exchange traded funds (ETFs), among others vehicles.
With ready index tradability, no longer is it the case that only changes in the price of the underlying stocks can change the value of an index. Now an index can change through direct action in it. When that happens, the directional action then gets translated through in to the component stocks. This is done by arbitrage type of activity whereby institutions buy or sell big baskets of shares all at once.
So the question that I recently saw brought up was whether owning an index means ownership of the stock. In the old days it would have. These days it does not necessarily, at least not directly. That said, though, if you own the DJIA, somewhere along the line the 30 stocks are being held. If you own an ETF you own part of a fund which holds the stocks. If you are long the futures, chances are that somewhere long the line there is someone holding the shares as a hedge. Same with index options.
I think the real question that was asked on the forum in terms of share ownership was whether the component stocks influence the index. The answer to that question is “of course”, since the “cash” index is still calculated based on those stock prices. We must now, however, add in to the equation the fact that the index can also influence the prices of the shares in them. It’s a two way street now.
Struggling with support & resistance and knowing what the key market levels are? Check out the Price Distribution Analysis methods I use.
Comments are closed.