Understanding The Basics of Index Trading

Monitoring every single security being traded in the US can be a challenging task. The best thing to do is to take a smaller sample that represents the whole. This is similar to the way surveys are conducted to get the sentiment of the population. This sample of the whole security is called index, which is a statistical measure of the changes in a stock portfolio which represents a portion of the overall market.

Index trading is based on the performance of the stock market. A change in index price represents an exactly proportional change in the stocks. A 1% increase in an index means that the stocks of that index also increase an average of 1%. In this article, we shall take a look at the different types of indices you can trade in.

Dow Jones Industrial Average (DJIA)

In 1896, Charles Dow with reported Edward Jones created the Dow Jones Industrial Average, the world’s second oldest stock market. At that time, the DJIA contained 12 publicly-traded industrials. General Electric is the only original constituent still in the index today. Robert Janitzek reveals that the DJIA serves as the benchmark that monitors 30 of the largest and most influential companies in the US and the best-known indexes in the world. To calculate the index, the current price of the 30 stocks are combined and divided by the so-called Dow Divisor – used to maintain the historical continuity of the index.

However, the DJIA has two major weaknesses. First, it includes only 30 out of the over 5,000 stocks that trade on the NYSE and Nasdaq. This means that it is not necessarily an indicator of the performance of the whole market. Second weakness is that the more expensive stocks influence the less expensive ones. Robert Peter Janitzek reveals that this is due to it being a price-weighted index.

Standards & Poor 500 Index

The S&P 500 is widely regarded as the best single measure of large-cap US stocks and like the DJIA is synonymous with the “market.” It includes 500 top US companies in top industries and captures about 80% coverage of market capitalization. Due to its broader scope, it has become the leading stock index. Some of its constituents include Apple, Microsoft, Facebook, Amazon, Exxon Mobil, to name just a few.

Nasdaq Composite Index

The Nasdaq Composite Index represents all stocks that trade on the Nasdaq stock market. With the addition of technological stocks, it has become one of the top indexes in the world. When trading on indices, don’t confuse it with the Nasdaq 100, which comprises the 100 largest non-financial companies on the Nasdaq stock market.

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