Markets and Indices Explained
What Is A Market?
Markets are the mechanisms through which financial dealing takes place. They represent the notional meeting place through which instruments can be bought and sold with a degree of liquidity, and provide a fluid, cyclical basis on which prices can adjust for supply and demand. When demand for an instrument increases, the price lifts incrementally to establish the value of holding the relevant instrument at that point in time, and vice versa for when there is excess supply in a particular market – be it for shares, commodities or some other asset class. This provides the opportunity for traders to speculate and profit from market outcomes, because the dynamic value allows traders to buy and sell for the difference in price. For this reason, buyers will back markets they think are going to perform well, in the anticipation that demand will increase at which point they can sell off their contracts for a higher price.
What Is It For?
Markets were designed principally to give merchants the ability to trade uniform lots of goods quickly and at fair value. As opposed to individually negotiating orders with specific customers and settling on custom terms and conditions for each transactions, the market allowed buyers and sellers to get together and agree on certain good at certain prices, opening up the playing field to a range of interested parties – both as end users and speculators. Today, the markets serve to provide a mechanism through which companies and governments can raise capital, manufacturers can sell their goods, and producers can buy and speculate on the raw materials they require in the course of their business. By bringing together vast numbers of buyers and sellers, including market makers like pension funds who serve as a temporary counterparty in times of lower liquidity, markets today allow virtually instantaneous buying and selling, by ensuring there is always sufficient supply to meet market demand, and sufficient demand to absorb supply.
How Does It Work?
Markets work in an elegant way to determine the right price point for the underlying asset. When buyers execute a buy order, their order is filled by a seller or a market maker holding excess stock of the particular requested share or asset, and each unitary purchase incrementally increases the market price. Conversely, as each unit is sold, the price decreases incrementally because this increases the supply of the asset available for purchase – i.e. it has become less scarce, and easier to buy, therefore its price has decreased. When a price becomes undervalued as compared to its inherent value – for example, where a share is priced at a point below its liquidated value, traders will be encouraged to buy on the assumption that the market will eventually correct in order to deliver them a profit. When prices rise to unsustainably high levels, traders will sell to cash in on their positions, and so a cyclical pattern of bidding up and selling down with dynamic pricing is created. It is this functionality that allows markets to express intricate sentiments about how they perceive underlying assets, economies and indices, and this which makes markets such a useful tool for forecasting and predicting future financial outcomes.
What Is An Index?
Another basis for trading CFDs, indices (or index, singular) are effectively notional markets that either aggregate the performance of other markets, or try to factor in other data into a numerical way. For example, CFDs could be bought on UK interest rates with some brokers, which are indexed to allow month on month and year on year comparisons. Or, a trader might invest in the S&P 500 – an index comprised of the aggregate of 500 large US companies. Unlike a market, where there is an underlying asset to be bought and sold, indices normally have no inherent value – they are simply artificially collated pictures of other assets, markets or factors to enable trading on a more widespread basis. Indices are a collection of assets priced up to give a single representative value on which traders can speculate, which enables forecasting to be made on wider economies and sectors without the need to invest in one particular market or asset.
What Is It For?
Imagine you, as a trader, see a glaring opportunity in the UK economy. A culmination of factors has come together to suggest that the UK as a whole will perform well, and the likelihood of a surge in the markets is significant. How best do you capitalise on this opportunity? Indices provide a means in this type of scenario whereby traders can invest more flexibly on markets that wouldn’t otherwise be open to them, for example using the FTSE100 as the basis for speculating as opposed to individual shares. Indices allow traders a heightened degree of flexibility as compared to trading in markets alone, and in the process enable traders to take advantage of the functions of CFDs on a broader range of investable bases.
Why are Markets and Indices Important?
Markets and indices are exclusively the basis on which CFDs can be traded. A contract for difference can relate either to an underlying market or index, with the relevant choice providing the numerical basis on which price can be computed. Without markets and indices, trading CFDs would be impossible, and similarly understanding their function and behaviour is an important piece in the puzzle as far as improving your trading success rate is concerned.