Experienced investors always go by the rule that says “Don’t put all your eggs in one basket”.
Trade the most famous stock indexes
2019-11-11 • Updated
Information is not investment advice
The index is a highly important trading instrument. Indexes have plenty of advantages. Thus, every trader should know about them. In this article, we will look at the three most important American indexes and determine their advantages. Let’s find out.
Standard & Poor's 500 Index - S&P 500 - is one of the most widely quoted American indexes as it represents the stock performance of 500 US largest publicly traded companies. However, checking the list, you will find 505 symbols because several companies have two share classes. For example, Facebook. The S&P market capitalization is 70 to 80% of the total US stock market. Moreover, the index is that it covers all US industries.S&P 500 considers different factors of companies such as market size, liquidity, and industry grouping before accepting them. The index gives a higher weighting to larger companies, not more expensive. The market capitalization of one company should be at least nearly $6 billion. Once a quarter, stocks are added or deleted as rules change, companies grow (or shrink), and merge.
S&P 500 is calculated by taking the sum of the market capitalization of all 505 stocks and then dividing it with an index indicator. The feature is that the index considers only the shares available for public trading.
Nasdaq Composite Index is the stock index of more than 3,300 companies that are listed on the Nasdaq stock exchange. Unlike S&P500, the list of companies is not limited by those who have only US headquarters. To be a part of the list, the security should be exclusively listed on the Nasdaq Stock Market (if only it was dually listed on another US market before January 1, 2004, and has continuously maintained such listing). There is also another restriction on the type of security. Only American depositary receipts (ADRs), common stock, limited partnership interests, ordinary shares, real estate investment trusts (REITs), shares of beneficial interest (SBIs), tracking stocks can be included in the index. As soon as the security doesn’t meet the criteria, it’s excluded from the index.
The index is calculated by multiplying the total value of the share by each security’s last price. Then the amount is divided by an index divisor. The index is calculated throughout the trading day with the final confirmed value at 4:16 p.m.
The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 North American stocks from different industries that are traded on the New York Stock Exchange and the NASDAQ. It’s the second oldest American market index. Since the past, the index performs the health of the American economy. At the moment of launch, the index included 12 stocks that were almost purely industrial. Nowadays, the index covers only companies with significant growth and investing capacity. So the stock list is not constant, companies are included and excluded based on certain non-quantitative criteria. As soon as a company survives financial difficulties, it is excluded. At the same time, the index excludes transportation and utilities, they are covered by the Dow Jones Transportation Average (DJTA) and Dow Jones Utilities Average (DJUA).
The index uses a price weighting methodology that gives more expensive stocks a higher weight. The DJIA is calculated by summing the component stock prices and dividing them by a divisor. The Dow Jones index shows the average value of stocks in those shares of capital that were selected for calculation at the time when the composition of the indicator was approved.
Now let’s move to the most important part for any investor – price prediction. Although indexes differ with the number of companies and ways of calculating, there is a list of rules you can use to predict their direction.
1. Check the list. The index consists of different securities. Each of them has its strength. The sum of them composes the strength of the whole index. The price of stocks, which compose an index, can change due to market capitalization, mergers, and acquisitions. It may lead not only to the change in the strength of the index but also to the changes in the list of stocks included.
2. Be aware of industries. After you find out what stocks will affect the direction of the index, it’s important to determine the industries. You should know that not only the components of the index have an impact on its direction but also the situation in the field they belong to.
3. Check the correlation between the domestic currency and the index. In most cases, you will find a positive one between them.
4. Last but not least, you should remember that usually, indexes reflect the health of the economy. Moreover, they are influenced by market sentiment. In times of uncertainties, indexes are supposed to weaken while positive economic data will push them up.
Advantages of index trading.
- Trading indexes you don’t have to be at a crossroads: what stocks to trade.
- Indexes are a kind of hedging instrument that will diversify risks of unpredictable moves. Stocks are sensitive to market sentiment. Thus, any news may cause high volatility.
- Indexes are a more stable instrument than stocks.
To conclude, the indexes are one of the most reliable trading instruments. They differ with the number of stocks, industries, ways of measurement. If you want to be successful trading indexes, follow simple rules that you learned in this article.
Although the market is flat 70% of the time, most of the trading strategies are for trend trading. Thus, most traders use only 30% of the trading potential! If you want to be more productive, pay attention to this strategy.
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