What Is an Index?

A market index is a single number that tracks the value of a group of assets. The S&P 500 tracks 500 large US companies, the Dow Jones Industrial Average tracks 30, and the Nasdaq 100 tracks 100 of the largest non financial companies listed on Nasdaq. When people say "the market was up 1% today", they usually mean one of these indexes.

Why indexes exist#

Thousands of stocks trade every day, and each moves for its own reasons. An index summarises them, so you can see at a glance how a market, sector or country is doing. Indexes also serve as:

• Benchmarks for judging fund managers and your own returns.
• The basis for investment products such as index funds, ETFs, futures and options.
• A gauge of risk and sentiment, especially volatility indexes like the VIX.

How an index is built#

Every index has a rulebook: which assets qualify, how many are included, how they are weighted and how often the list is updated.

Weighting methods#

Because a handful of very large companies dominate cap weighted indexes, the index can rise even when most of its members fall. Traders watch market breadth, how many stocks are rising versus falling, to see whether a move is broad or narrow.

Changes to the list#

Index providers add and remove members periodically, for example when a company grows large enough or shrinks too small. Funds tracking the index must then buy or sell, which can move prices around the change date. See Index Rebalancing.

Major indexes traders follow#

You cannot buy an index directly#

An index is a calculation, not a security. To trade it, you use products that track it: index funds and ETFs, index futures such as the E-mini S&P 500, index options, or CFDs where they are legal. See Index Trading.

How traders use indexes#

• Market direction. Many traders only take long trades in individual stocks when the broad index is in an uptrend.
• Relative strength. Comparing a stock's performance with its index shows whether it is leading or lagging.
• Hedging. A trader holding several stocks can sell index futures to reduce exposure to a market wide fall. See Hedging.
• Beta. A stock's beta measures how much it tends to move relative to the index.

Price index vs total return index#

Most headline index numbers are price indexes: they ignore dividends. A total return version assumes dividends are reinvested. Over long periods the difference is large, so compare like with like when judging performance.

Frequently asked questions#

What is the most important stock index?#

The S&P 500 is the most widely used benchmark for US stocks and for many global investors, though the Dow and Nasdaq are also closely followed.

Can an index go down while most stocks go up?#

Yes, in a cap weighted index, if a few very large companies fall while many smaller ones rise. The reverse can also happen.

What does it mean to track an index?#

A fund that tracks an index holds its members in roughly the same weights, so its returns closely follow the index, minus fees.

Sources#

• S&P Dow Jones Indices, S&P 500
• Wikipedia, Stock market index