When we hear about markets being up, down, bullish, or bearish we are often actually talking about the performance of indices rather than the market itself. It is difficult to measure the stock market as a whole, so instead a lot of analysts use metrics that summarize the performance of a sample of stocks. These days indices are the basis of some of the most popular investment strategies.
Indices take a sample of stocks deemed to be representative of a country, sector, or other area and then somehow average their prices to come to the indices level. This level by itself does not matter much but by following its percentage changes over time, investors can approximate the movement of the underlying market. A lot of people use indices as a proxy for the markets they sample. In fact, it has become a popular practice to invest in the indices themselves to achieve market returns.
It should be noted that there are plenty of indices to choose from when trying to gauge the markets. In fact, there are more indices but only a few are as popular as the famous Dow Jones and S&P 500. In this article, we will further analyze what the indices mean and how it is traded in the financial markets. Besides, we will talk about what are the main differences between trading with indices and trading with Forex and indices vs forex which is more profitable.
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As we have already mentioned, one of the most widely watched indexes is the S&P 500 that is seen as of the best representations of US companies as it follows the performance of 500 at the largest but not the 500 largest US companies based on the market.
Another important index that should be noted here is the Nasdaq Composite Index which is unique in that it measures the price of stocks trading on its own market, also called the Nasdaq. The Dow, S&P 500, and Nasdaq all track the US stock market but indices exist for other countries as well. If you are interested in following Canadian stocks you can check out the SP TSX composite. On the other hand, for a more global perspective, there is the MSCI World Index. These broad market indices track the performance of a large group of stocks in a country. However, if you want to know more industry-specific information, there are indices that cover these issues as well.
For example, if you wanted to follow US technology, Canadian banks, or international healthcare stocks, you could check the above-mentioned indices (including Dow Jones and S&P 500) in order to get an idea of how the markets have moved over time.
As you can see there are plenty of indices to look at when trying to compare the performance of your stocks to the overall market. On the other hand, their utility has a past as a mere point of reference.
While talking about how index trading works it should also be stated that since indices like the SP 500 are meant to represent the market as a whole and because they are diversified by nature, a lot of investors have started using index funds as an easy way to gain investment exposure while keeping costs low.
The index fund is a mutual fund or more broadly an ETF that mimics an index by either holding all of its constituents or holding a representative sample. Because index funds simply copy an index they can operate at a lower cost and often charge you fees below half a percentage point. This makes them a popular option for passive investors who believe mimicking the market is better than trying to beat it. Though active investors have also adopted index funds as a way to expand and limit their exposure to certain industries and countries.
Most Traded Index in The World
Before explaining the indices compared to Forex it should be mentioned that there are several most traded indices around the world. Those indices include the S&P 500 index and The Dow Jones.
When it comes to stock market indices, probably one of the heaviest traded around the world is S&P 500. The S&P 500 is based on, amongst other factors, the market capitalization of the 500 largest companies traded on the US market. The S&P is considered to be a truer reflection of the broader US stock market when you compare it to something like the Dow Jones.
It is traditionally a way of gaining broad exposure to large US-listed shares. So maybe rather than investing in one share, buying or selling the S&P gives you exposure to a whole cross-section of the US market. it has been really popular for decades and continues to be a very successful index even today.
On the other hand, The Dow Jones Industrial Average is the second oldest US stock market index, after the Dow Jones transportation average. Even people who are not involved with trading into the financial markets are probably familiar with the Dow being used as a benchmark for a US stock market performance. It tracks the value of the 30 largest US stocks. This includes the companies such as Coca-Cola, Caterpillar, Apple, Microsoft, Nike, and McDonald’s. This information is being updated regularly to reflect the changing nature of US business.
If you are buying or selling the Dow Jones index, it is a great way of gaining broad exposure to a group of large US-listed shares. On the other hand, from the trading point of view, it is clearly a market that even on a quiet day can swing around quite substantially. Therefore this daily volatility is one of the main reasons that it appeals so much to most traders.
How are the Indices Traded?
While we talk about how index trading works there are several important things that traders need to take into account. First of all, traders should remember that different indices can provide totally different returns even if they track the exact same market segment. The reason for this is twofold.
The first is that indices may have different sample sizes and criteria, The Dow Jones for example has a much smaller universe of stocks than the S&P 500. The second reason which is a bit trickier to understand is that indices can follow different methods for calculating their level.
It should be noted that indices use one of four different weighting methods when averaging the prices of their stocks. depending on the method used, you may find an index moving at a different rate or even a different direction than other indices.
Let’s say we have four indices that all measure the price changes of the same three stocks. each index Falls one of four different weighting methods. So as the stocks change in value, each of the index levels will show a different return. The pric