What is an index?
One of the most common questions asked by investors is, “How’s the stock market doing?” The answer can be found in an index.
An index is a collection of stocks that are used to measure changes in the overall stock market.
For example, if you know that the Dow Jones Industrial Average (DJIA) increased by 2%, it means that most companies did as well.
Market Indices
There are many different types of indices, e.g. the Dow Jones Industrial Average (DJIA), and S&P 500 (SPX).
These indices are also referred to as ‘market barometers’ because they are used by investors as an indicator of how well their investments are doing relative to broader markets.
The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 large companies’ stock prices.
The S&P 500 Index is a market capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy.
How are indices calculated?
An index is calculated by adding up the prices of stocks.
The price of each stock is weighted according to its market capitalization.
In other words, the larger a company’s market capitalization (i.e., the number of shares times share price), the more its movements affect the overall value of an index.
Types of Stock Market Indices
Here are the most common ways to look at stock market indices:
- Price-weighted
- Capitalization-weighted
- Equal-weighted
- Fundamentally weighted
- Momentum
- Reversal
- Investment-grade
- Liquidity
How can you read an index chart?
The first thing you will want to do when looking at an index chart is read it from left to right.
The next thing is to look for trends and patterns.
If the index has a tendency to go up or down over time, look for whether or not it continues that trend on the chart you are viewing.
Look for price action as well. Pay attention to what was occurring just before the price move (support/resistance) and how far away from those levels were prices when they were broken through.
Look for volume because this can confirm your analysis of support and resistance levels.
Indices are a good way of tracking the overall direction of the stock market.
Key Points
Indices are used to measure the overall performance of a market, sector or industry by tracking its key components.
For example, if you want to track healthcare companies in America then you might use an index that has names in it like CVS Health Corp., Humana Inc., and UnitedHealth Group Inc.
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