A stock index is used to describe the performance of the stock market, or a specific part of it and to compare the returns on investments. In general, an index uses a weighted average of stock prices. The NASDAQ, S&P 500 and the Dow Jones Industrial Average are examples of stock indexes. In this article, we will tell you all about the indexes, as well as how to make money with them.
What Is an Index
Since it would be too difficult to track each and every one of the securities that are traded, we take a smaller sample of the market that is representative of the whole - similarly to the pollsters use surveys to measure the sentiment of the population. This smaller sample is called an index, which is a statistical measure of changes in a portfolio of stocks that represent a portion of the overall market.
Investors and other market participants use indexes to track the performance of the stock market. Ideally, a change in the price of an index represents an exactly proportional change in the stocks included in the index: if an index rises by 1%, for example, it means that the stocks that make up that index have also increased by an average of 1%.
Let's see how indexes work, using a simple example:
Suppose we created an index to track the price of a gallon of milk.
Milk consumption costs $2.00 per gallon.
The initial index value is 1.
- When milk costs $2.50, our index will be 1.25, which reflects a 25% increase in the price of milk.
- If the milk costs $2.25, the index is 1.15. The change of .10 reflects a 10% decrease in the price of milk.
If you were a milk distributor, you might find the milk index very useful. I would use it instead of going to the store every day to write down the prices of each competitor's milk and draw an average.
Stock indexes are used by traders, economists and academicians, but each one would use the information in a different way.
History of Index Creation
In 1896, Charles Dow - who along with his fellow journalist Edward Jones founded Dow Jones & Company - created the Dow Jones Industrial Average (DJIA), the second oldest stock exchange index in the world (the oldest is the Dow Jones Transportation Index, also created by Dow). At that time, the DJIA contained 12 listed industries, including General Electric, the only original constituent remaining in the index. Today, the Dow is a benchmark that tracks 30 of the largest and most influential companies in the United States and is one of the best-known indices in the world.
The original function of the indexes was to act as a barometer of the stock markets, offering observers a concrete measure of the appetite of investors or potential IPO prospects. They still do this, up to a point.
In the 1920s, however, the indices had evolved from barometers to benchmarks intended to measure market performance. In the 1960s, designed with the Capital Asset Pricing Model (CAPM) and with the capitalization weighting structure in mind, the indexes began to be used to describe the reference market, from which they could be compared the results of the active investment managers.
How Are the Indices Calculated
Before the digital era, calculating the price of a stock index had to be as simple as possible. The original DJIA was calculated using a simple average: add the prices of the 12 companies and divide that number by 12. These calculations made the index really not more than an average, but it served its purpose.
Today, the DJIA uses a different methodology called weighting based on price, where the components are weighted according to their prices. To calculate the index, the current prices of the 30 shares are added and then divided by what is known as the Divisor Dow, a number that is used to maintain the historical continuity of the index. This number is continuously adjusted to take into account changes in the market, such as equity divisions, spin-off and any changes in the Dow components. In 2008, for example, the value of the Divisor Dow was 0.125553. Today, it is 0.14602128057775.
Most indexes weigh companies according to market capitalization instead of price. If the market limit of a company is $1,000,000 and the value of all the shares in the index is $100,000,000, the company would be worth 1% of the index. The indices are continuously calculated to provide accurate reflections of the market throughout the trading session.
The Most Popular Indices
Dow Jones Industrial Average
The Dow Jones Industrial Average (DJIA) is one of the oldest, best known and most used indices in the world. Includes the shares of 30 of the largest and most influential companies in the United States. The DJIA is what is known as a weighted price index. Originally it was calculated by adding the price per share of the shares of each company in the index and dividing this amount by the number of companies; that's why it's called average. Unfortunately, it is no longer so simple to calculate. Over the years, stock divisions, spin-offs and other events have caused changes in the divisor, which makes it a very small number (less than 0.2).
The DJIA represents about a quarter of the value of the entire US stock market. UU., But a percentage change in the Dow should not be interpreted as a definitive indication that the entire market has fallen by the same percentage. This is due to the function weighted by the price of the Dow. The basic problem is that a change of $1 in the price of a stock of $120 in the index will have a greater effect on the DJIA than a change of $1 in the price of a share of $20, although the shares of higher price may have changed only 0.8% and the other 5%.
A change in the Dow represents changes in investor expectations about the gains and risks of large companies included in the average. Because the general attitude toward large-cap stocks often differs from the attitude toward small cap stocks, international shares or technology stocks, the Dow should not be used to represent sentiment in other areas of the market. On the other hand, because the Dow is composed of some of the best known companies in the US. In the US, the large swings in this index generally correspond to the movement of the entire market, although not necessarily on the same scale.
The Standard & Poor's 500 index (commonly known as the S&P 500) is a larger and more diverse index than the DJIA. Composed of 500 of the most sold stocks in the United States, it represents approximately 80% of the total value of the US stock markets. In general, the S&P 500 index provides a good indication of the movement in the US market.
Because the S & P 500 index is weighted by the market (also called weighted capitalization), each share in the index is represented in proportion to its total market capitalization. In other words, if the total market value of the 500 companies in the S&P 500 falls by 10%, the value of the index is also reduced by 10%.
A 10% move in all stocks in the DJIA, on the other hand, would not necessarily cause a 10% change in the index. Many people believe that the market weighting used in the S&P 500 is a better measure of market movement because two portfolios can be compared more easily when changes are measured in percentages rather than dollar amounts.
The S&P 500 index includes companies in a variety of sectors, including energy, industry, information technology, healthcare, finance, and consumer goods.
Most investors know that the Nasdaq is the exchange in which technology stocks are traded. The Nasdaq Composite Index is an index weighted by stock market capitalization of all stocks traded on the Nasdaq Stock Exchange. This index includes some companies that are not based in the US.
Although this index is known for its large share of technology stocks, the Nasdaq Composite also includes shares of the financial, industrial, insurance and transportation industries, among others. The Nasdaq Composite includes large and small companies but, unlike the Dow and the S&P 500, it also includes many speculative companies with small market capitalizations. Consequently, its movement generally indicates the performance of the technology industry, as well as the attitudes of investors towards more speculative actions.
DAX is a stock market index representing 30 of the largest and most liquid German companies listed on the Frankfurt Stock Exchange. The prices used to calculate the DAX index come from Xetra, an electronic commerce system. It is a capitalization-weighted index, so it essentially measures the performance of the 30 largest listed companies in Germany. Therefore, it is a strong indicator of the strength of the German economy and of investor sentiment towards German stocks.
The DAX was created in 1988 with a base index value of 1,000. DAX member companies represent approximately 75% of the aggregate market capital that is traded on the Frankfurt Stock Exchange.
It is the main European stock market index in the global market.
The name FTSE 100 originates when it was owned 50/50 by the Financial Times and the London Stock Exchange (LSE), hence FT and SE produce FTSE. It also refers to its composition of 100 companies.
The FTSE 100 (more colloquially known as the Footsie) is an index composed of the 100 largest companies (by market capitalization) listed on the London Stock Exchange (LSE). They are often referred to as "frontline" companies, and the index is considered a good indication of the performance of the major companies listed in the United Kingdom.
Larger companies make up a larger portion of the index because it is weighted by market capitalization. The FTSE 100 is managed by the FTSE Group. It is calculated in real time, and when the market is open, it is updated and published every 15 seconds.
The FTSE 100 is often seen as an indicator of prosperity among UK rated companies and the economy in general. However, a large part of the companies included in this index are based in other countries.
Index CFD Trading
The CFD’s or Contracts for Difference are one of the fastest growing financial products in the current market. They offer traders the opportunity to negotiate all the stock indices of the world from a platform, while gaining access to incredible levels of leverage.
To get more information about what CFD is, you can follow the link.
With the help of CFD indices, you can earn on the fluctuations of the indices in the same way as on the value of stocks or exchange rates.
When taking a CFD position, a trader is essentially in agreement to change the difference in the price of an index from one period of time to another. In other words, the CFD is an agreement between the buyer (you) and the Broker to exchange the difference between the current value of an index and its value at a future time. If you hold a long position and the difference is positive, the Broker pays you. If it is negative, you pay the Broker.
The price of the CFD index is directly related to the price of the related future. The price movement of the CFD Index tracks the movement of the related future.
The CFD trade in indexes provides an excellent way to speculate on the performance of each stock market in general, rather than selecting stocks and individual stocks. In fact, index CFDs are often considered less risky than individual stocks, as the risk is spreading across the market rather than in a single company.
We hope this article is useful for you. And we invite you to try to operate with Index CFD at this very moment by opening a free demo account at Libertex. In it you can practice CFD trading without risking anything. In addition, we recommend that you take a free online course.