Three things an index spread better should know

Many spread betters start off trading equity indices. Ans while they seem straightforward enough, they are not all created equal. Tim Bennett explains the three key differences.

One of the keys to successful spread betting is to understand the market you are getting into. According to Cityindex many investors start off with equity indices, presumably because they seem straightforward. But do they really understand what they are betting on?

Share indices are often used to provide a snapshot on a market. Spread betters might choose to bet on the direction of a single index or perhaps even a pair (the FTSE 100 versus, say, the Nikkei 225). All major indices represent the top shares in their respective markets (FTSE 100 UK, Dow Jones 30 US), and all are very well established.

For much of the time the major indices can follow a broadly similar price pattern - Tokyo opens first, then London and finally New York; each responds to new data in a similar way usually - so many traders will look for clues about the direction of a particular index based on what's happened in other major markets. But be aware that this doesn't always work - in part because you are not comparing like with like. Not all share indices were created equal. Here are three key differences.

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For one thing there are the constituents. The FTSE 100 represents 100 companies here, whereas the Dow Jones is just 30. Over in Tokyo, the chosen number for the main index is 225. So the firms that make up each index are very different. And if you switch, say, the Dow Jones 30 for the equally popular, and broader, S&P 500, you suddenly have a US index that is more like our FTSE 100 and FTSE 250 combined, not just our FTSE 100.

Then there's a mechanical difference in the way indices are constructed. The Dow Jones, for example, selects companies on the basis of their share price, whereas the FTSE 100 does it on the basis of market capitalisation (shares in issue multiplied by the latest share price). The S&P 500 is also a market capitalisation driven index (it is 'value' rather than 'price' weighted). There are pros and cons to both methods - value weighted indices can be skewed by very big companies for example. But the point is that the method can affect the way an index such as the FTSE 100 behaves if a giant such as BP suddenly takes a nosedive as it did fairly recently.

Finally, there's the thorny and grim-sounding issue of arithmetic versus geometric averaging. Take the following simple performance stats; +90% +10% +20% +30% and -90%. An arithmetic average for these adds them up and divides by five to give 12%. Geometrically, the average is -21%. So if you are comparing FTSE 100 performance calculated arithmetically against another index done geometrically, again it's apples and pears time.

None of this should put you off index bets. For much of the time these differences won't affect you directly. But be prepared for a few surprises when they do, and use stop losses so you don't get badly caught out.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.