A stock market index represents the value of a given section of the stock market. An index takes a number of stocks of different companies and groups them together in a way that they can be traded as a single financial instrument.
For example, the DJIA (Dow Jones Industrial Average) is one of the most popular and regularly used indices in the world, representing about 25% of the US stock market with stocks from 30 of the largest companies in the country. The S&P 500 is another popular index that consists of 500 of the most traded companies in the US, representing about 70% of the total finance value of all the US traded stocks. Since the S&P 500 is considerably more diverse than the DJIA, it gives a much better representation of how the US stock market is performing as a whole.
In general, the value of an index is represented in terms of points. Each index is calculated differently, but the underlying value denotes the weighted average of the current value of its constituent stocks. As such, how the value of an index changes from one day to the next reflects fluctuations in the value of individual component stocks, and this is why indices are better representations of how an economy or a specific industry is performing.
Types of Indices
Stock market indices can be categorized in many different ways. A global or world index is comprised of companies regardless of where in the world they are traded or based. A National index reflects the stock market performance in a given country and therefore shows the investor sentiment on the state of the economy. The most popular national indices consist of stocks of the largest companies in the country’s stock market such as the S&P 500 of the US, the U.K.’s FTSE 100, and the Japanese Nikkei 225.
Other indices relate to given industry sectors. For instance, the NASDAQ 100 is primarily composed of companies in the technology sector and totally omits companies in the financial sector.
Investors can trade indices, going long if they believe that the component stocks of that particular index will increase overall in the future, or go short if they predict the value of the index will decrease in the future.
Industry or sector focused indices let you form a position on whether a given industry has good or bad prospects and actually place a trade based on that. For instance, if you believe new regulations in the US might threaten the ability of banks in the country to turn a profit, you may decide to sell the KBW Bank Index, which is made up of 24 stocks of banking companies across the US.
Certainly, an in-depth knowledge of a given industry will come in handy here. However, it’s still possible to trade sector indices based on the outlook of the overall state of the country’s economy. Some sectors on economy are cyclical in nature, meaning that they perform better at times of economic growth and suffer during a downturn, such as the construction industry.
You can therefore decide to buy or sell given sector indices depending on how the economy is doing and how its future outlook appears to be. For example, in economic booms you may decide to buy the cyclical industries, while in a downturn by defensive sectors (e.g. pharmaceutical industry) and sell the cyclical sectors.