The benefit of stock indices for the investor or trader is not having all your eggs in one basket. Invest in a single stock and you’re living and dying by your decision. If it goes up, you’re fine. But you could also find yourself losing money on a stock even while the overall market is rallying. Numerous studies have shown that indices tend to outperform manually selected stock portfolios in the long run.
Indexing tracks the performance of a group of stocks using a weighted average or similar calculation. You can trade indices using instruments such as stock funds, exchange-traded funds (ETFs), and futures contracts, options, and binary options derived from stock indices.
It is important to understand the differences between these stock index instruments as well as the calculation.
The benchmark index for large-cap stocks in the US is the Standard & Poor’s 500 or S&P 500. The S&P 500 is a market cap-weighted index which means the proportionate value of each stock in the index is calculated by multiplying the individual price of the stock by the number of shares outstanding. The S&P 500 is referred to as the market value.
The second oldest US index is the Dow Jones Industrial Average, which includes 30 large cap companies. The Dow is the most well-known to the general public and commonly reported in the news. It is a price-weighted index, not market cap-weighted like the S&P 500. This means that a $1 increase in the price of a $20 stock has the same impact on the Dow as a $1 increase in a stock priced at $120. Even though the $1 move on the $20 stock is a 5% move, versus the 0.83% move in the other stock, they are weighted the same.
The Dow Jones Industrial Average is the summation of the 30 stock prices, divided by a divisor known as the Dow Divisor.
Numerous other stock indices exist in global markets. Among the largest are the Nasdaq and Russell 2000 in the US, as well as Germany’s DAX, the UK’s FTSE 100, Japan’s Nikkei 225, and the China A50. All of these indices can be traded on Nadex.