Index trading is a type of trading of a group of stocks which make up the index.[1] An index is a measurement of the value of a section of the stock market. It is computed from the prices of selected stocks. It may also be referred as a group of stock market publicly listed uppermost businesses within a region.
There are numerous stock market indices within the world such as S&P/ASX 200 (Australia), FTSE100 (London), CAC 40 (France), AEX index (Amsterdam), and DAX (Germany), IBEX 35.
Indices can be constructed as a broad-based index that captures the entire market, such as the Standard & Poor’s 500 Index or Dow Jones Industrial Average (DJIA), or more specialized such as indexes that track a particular industry or segment such as the Russell 2000 Index, which tracks only small-cap stocks.
Passive index investing has become a popular low-cost way to replicate the returns of popular indices such as the S&P 500 Index or Dow Jones Industrial Average.
Benchmarking your investment strategy against the appropriate index is key to understanding a portfolio’s performance.
Indexes are also created to measure other financial or economic data such as interest rates, inflation, or manufacturing output. Indexes often serve as benchmarks against which to evaluate the performance of a portfolio’s returns. One popular investment strategy, known as indexing, is to try to replicate such an index in a passive manner rather than trying to outperform it.
An index is an indicator or measure of something. In finance, it typically refers to a statistical measure of change in a securities market. In the case of financial markets, stock and bond market indexes consist of a hypothetical portfolio of securities representing a particular market or a segment of it. (You cannot invest directly in an index.) The S&P 500 Index and the Bloomberg US Aggregate Bond Index are common benchmarks for the U.S. stock and bond markets, respectively.
In reference to mortgages, it refers to a benchmark interest rate created by a third party.
Each index related to the stock and bond markets has its own calculation methodology. In most cases, the relative change of an index is more important than the actual numeric value representing the index. For example, if the FTSE 100 Index is at 6,670.40, that number tells investors the index is nearly seven times its base level of 1,000.
However, to assess how the index has changed from the previous day, investors must look at the amount the index has fallen, often expressed as a percentage.
Index Investing
Indexes are also often used as benchmarks against which to measure the performance of mutual funds and exchange-traded funds (ETFs). For instance, many mutual funds compare their returns to the return in the S&P 500 Index to give investors a sense of how much more or less the managers are earning on their money than they would make in an index fund.
“Indexing” is a form of passive fund management. Instead of a fund portfolio manager actively stock picking and market timing—that is, choosing securities to invest in and strategizing when to buy and sell them—the fund manager builds a portfolio wherein the holdings mirror the securities of a particular index. The idea is that by mimicking the profile of the index—the stock market as a whole, or a broad segment of it—the fund will match its performance as well.
Since you cannot invest directly in an index, index funds are created to track their performance. These funds incorporate securities that closely mimic those found in an index, thereby allowing an investor to bet on its performance, for a fee. An example of a popular index fund is the Vanguard S&P 500 ETF (VOO), which closely mirrors the S&P 500 Index.
When putting together mutual funds and ETFs, fund sponsors attempt to create portfolios mirroring the components of a certain index. This allows an investor to buy a security likely to rise and fall in tandem with the stock market as a whole or with a segment of the market.
Index Examples
The S&P 500 Index is one of the world’s best-known indexes and one of the most commonly used benchmarks for the stock market. It includes 80% of the total stocks traded in the United States.
Conversely, the Dow Jones Industrial Average is also well known, but represents stock values from just 30 of the nation’s publicly traded companies. Other prominent indexes include the Nasdaq 100 Index, Wilshire 5000 Total Market Index, MSCI EAFE Index and the Bloomberg US Aggregate Bond Index.
The FTSE 100, Dax 40 and CAC 40 are all popular indices in Europe.
How are Indices Constructed?
- Indexes can be built in a number of ways, often with consideration to how to weight the various components of the index. The three main ways include:
- A market-cap, or capitalization-weighted index puts more weight in the index to those components that have the largest market capitalization (market value), such as the S&P 500
- A price-weighted index puts more weight to those components with the highest prices (such as the Dow Jones Industrial Average)
- An equal-weighted index allocates each component with the same weights (this is sometimes called an unweighted index)
Why Are Indexes Useful?
Indexes are useful for providing valid benchmarks against which to measure investment performance for a given strategy or portfolio. By understanding how a strategy does relative to a benchmark, one can understand its true performance.
Indices also provide investors with a simplified snapshot of a large market sector, without having to examine every single asset in that index. For example, it would be impractical for an ordinary investor to study hundreds of different stock prices in order to understand the changing fortunes of different technology companies. A sector-specific index can show the average trend for the sector.
Indices provide a broad representation of how markets are performing. These indexes serve as benchmarks to gauge the movement and performance of market segments. Investors also use indexes as a basis for portfolio or passive index investing. In the U.S. such representative indexes include the large-cap S&P 500 and the technology-heavy Nasdaq 100.