What Are The Main Stock Market Indices and How Can Traders Use Them Efficiently?
Would you like to trade in the stock market and avoid high volatility? There are many ways that will help you, one of which is trading stock market indices. It’s the best option to limit market fluctuations and hedge your portfolio.
Stock Market: Definition
Before we move to the concept of a stock index, let’s clarify what the stock market is. The stock market is a place represented by different markets and exchanges where equities of publicly-held companies are bought, sold, and issued. All the financial activities in the stock market are held on formal exchanges or over-the-counter marketplaces.
Even though the stock market is a common name for the world market, every country has its own markets with stock exchanges, stocks, and indices. If you want to trade equities, there are several options. You can invest in real company’s stocks, trade stock CFD, and trade stock indices.
What Is a Stock Index?
A company’s stock, equity, or so-called share is a security that is sold by the company’s owner to attract investments. The equity gives its investor the right to own the company in proportion to the number of shares he/she owns. Now that we know that a company can go public and sell its shares in the market.
When we talk about a stock index, we do not mean only one company, but many companies that make up the index. Thus, an index is a benchmark that includes equities of the companies usually placed on a particular stock exchange.
The companies included in an index can change if they don’t meet the index’s requirements.
However, an index can’t include all the companies listed on the exchange. Thus, every index has the requirements for the companies. Mostly, an index consists of those with the largest capitalization. Therefore, if a company suffers losses or what is worse, it goes bankrupt, it will be excluded from the index and replaced by another one.
Stock Market Index: Basics
All indices can be grouped by the sphere they represent. The types of indexes can reflect the health of the entire country. For example, DAX 30 relates to the German market; Israel 35 represents the Israeli market. An index can refer to a specific industry, for instance, the Nasdaq Composite Index. Or just refer to a group of the country’s stocks, e.g., the S&P 500.
A stock market index is used as a gauge of the whole market sentiment.
In general, an index represents the health of a country or industry it relates to. As an index consists of different stocks, if their price goes down, the index falls. If the price rises, the index increases. However, you understand that it’s impossible for all the stocks to rise or fall at the same time. Thus, as many shares represent an index, only significant price changes can make it move and only essential events in the market force it to move.
Indices are calculated in different ways, but most of them reflect the average meaning of the current value of the included stocks. Usually, companies with larger capitalization have a more significant impact on the index value.
There are two methods of index calculation. They are direct and indirect:
- The direct approach is more straightforward. To calculate the index value, you need to add the prices of all stocks included in the index. This will be the value of the index. In this method, all the stocks are weighted equally. Thus, there is no company that will have a more significant impact on the index value.
- The second method is an indirect calculation. To calculate the index in this way, you should add the values of all the index stocks, divide the sum by the number of stocks, and multiply the result by the average trade turnover of each equity. Then, add the results to get the index’s trading turnover weighted price. As you can see, with this method, the stocks are estimated unequally. Thus, some will affect the overall index value more strongly.
You can find a particular method of calculation on the exchange’s website. However, if the index is not as famous as the S&P 500 or Nasdaq composite, there is a chance you won’t find the calculation method.
Why Stock Index Matters
Stock indices aren't that widely used among traders as currencies or commodities. But they are crucial for those who evaluate global market sentiment. If you read news about the stock market, you will see that every financial news agency mentions stock indices at least several times per day to reflect the current market events.
Thus, we can say that the index is crucial as it determines the economic health of the country or particular industry it relates to.
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