The Importance Of Stock Market Indices
Hello, traders. Welcome to the Stock Trading Course and the second module: Stock Market Indices. In this lesson, we are going to define what stock market indices are and why they are important for us to monitor them, as stock traders. So, let’s start by defining them. What are stock market indices? A stock market index is a measurement of the value of a section of the stock market. Its price is compounded from the prices of selected stocks. This means that a stock index is basically a benchmark for the economy, or for some sectors of the economy. So, there are two ways of calculating an index price, and these two ways of calculating an index price are not selected by us traders, but are selected by the indices themselves.
There is the first one, which is the weighted average index. This kind of indices base its price on the market cap of the companies in it. And the price weighted index bases it price on the shared price of the companies in it. So, basically, these two ways of measuring the stock index price really don’t matter for us traders, because, well, a movement in stock price will definitely change the market cap of a company, and also the share of the price itself. The price movements in the indices reflect the price movement in the companies in it. So, this means that the bigger the company, the more weight it has on the index and the more it will affect its price.
Now here is an example of a hit map. This is the S&P 500, with all the sectors that are in the S&P 500. And if we look, for example, here at Apple and Microsoft, their weight in the S&P 500 is much, much greater than for example, Goldman Sachs here, GS, or Citigroup here, C. Those are the tickets for GS for Goldman Sachs and for Citigroup. But, you can see their weight in the S&P 500 is less than the weight of Apple and Microsoft. Okay? Now the weight inside of the financial sector of the S&P 500 is greater than other banks or other financial institutions, but their weight on the overall index is not as great as Apple or Microsoft.
So, the bigger the company, the more weight it has on the index, okay? And, of course, if a company that has a bigger weight on the index moves a lot, then the index will also move with it. Some indices represent the performance of the stock market of a given nation and reflect investor sentiment of its economy. For example, the S&P 500 is the benchmark for the economy in the United States, the FTSE100 for the UK and the Nikkei 225 for Japan.
So, why is it important to monitor these indices? Not only these indices will give you an idea of the overall health of the economy, but it is also an important tool for market sentiment. Now, for example, if you have decided that Amazon is undervalued at these levels right now and want to buy it, but the S&P 500 has under-performed for the past week and is now -6.5% week-to-date, you might want to hold and reconsider your trade. So, basically, when you are considering a short term trade, or even a day trade, you have to look at the stock indices, and how they are performing because based on their performance you can have clues if whether your trade is going to be profitable or not.
Also, you can monitor sectors with the stock indices. The indices can also be used to monitor sectors in the economy and make sector-related trades. For example, if you are a biotechnology trader, you might want to monitor the biotech sector of the Dow Jones Industrial Average. Sometimes the overall sentiment of the economy can be negative, but selected sectors in it can really perform. This is why, as a stock trader, it is important not only to monitor stock indices, but also be sector-diversified when it comes to actual trading.
Now, let’s go back to the hit map of the S&P 500 and you can see that we have the technology sector of the S&P 500, we have the financial sector of the S&P 500, the consumer goods, the healthcare, utilities, services, etc. Now, if for example, you are interested in banks or the financial sector of the economy, you might want to look how the financial sector of the S&P 500 is performing. As you can see, even though Apple is really taking a dump today and well, the overall technology sector is not looking as good, the financial sector is looking very healthy. So, you might want to hold your trades on the technology sector and go to the financial sector to get better trades, out of the stock market. And, you can pull much more money by looking at the sectors that are actually performing today, than just blindly trading the same stocks day after day.