When people think about the stock markets, major indices such as the Dow Jones (properly known as the Dow Jones Industrial Average or DJIA) are among the first that come to mind.
But what exactly is a stock index and how is it put together? This explainer should help make sense of some of the jargon.
Stock indices attempt to track the overall movement of a market by calculating the average movements of a variety of stocks traded on one or several stock exchanges. The most prominent US-based indices are ‘the Dow’, the S&P 500, the NASDAQ Composite Index (‘the NASDAQ’) and the Russell 2000.
Online trading and Forex brokers, like UFX, let you trade Contracts For Difference (CFDs) on entire indices. Because CFDs have leverage, you can trade with a ratio of up to 20:1. While a little bit more risky than standard trading, trading Index CFDs can be quite lucrative for online and day traders, for both long and short positions.
The Dow is a price-weighted index that tracks thirty of the largest and most influential companies in the US, most of which are household names. Its composition and calculation have both changed significantly over the years. The index also has its own divisor to compensate for factors such as stock splits and spin-offs that would otherwise artificially skew the number.
The Dow represents about a quarter of the US stock market, but due to its price weighting, fluctuations are not indicative of overall market conditions. Its primary usefulness to investors is to gauge investor appetite for the major US multinational stocks, an important segment of the broader economy.
The S&P 500, compiled by Standard & Poor’s, offers a wider market perspective and each of its constituents is weighted according to its total market capitalization. The index contains securities from many different market sectors and many believe that its weighting system offers a more realistic picture of true market conditions, as opposed to the Dow Jones.
The NASDAQ Composite Index tracks the movement of the NASDAQ stock market, a technology stock exchange. Unlike the Dow and the S&P, the NASDAQ Composite also includes listings of micro-cap or speculative companies, in addition to some overseas firms. Its usefulness lies in tracking both the technology sector as a whole, as well as individual speculative stocks.
Finally, the Russel 2000 is a market capitalization-weighted index of the 2,000 smallest stocks in the Russell 3000. The index gained popularity during the 1990s, when small cap stocks were particularly sought-after. It covers a broad selection of industries and is indicative of the trading direction of small US companies.