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Trading Basics Part 2: What is an Index?

Stock market indexIn part one of our stock trading basics series, we explained that stocks are minute percentages of a company’s ownership, and they are traded on exchanges. Now we’re going to cover what an index is, and the different types out there today.

The first index: Dow Jones Industrial Average

Just before the turn of the century, in May of 1896, Charles Dow and his business associate Edward Jones first calculated and published their index, aptly named the Dow Jones Industrial Average (DJIA).
At the time, there may have been some 100 – 120 publicly traded entities. Charles Dow was the editor of the Wall Street Journal (WSJ), so he and Jones tracked the price movements of those stocks and published them in the WSJ. Thus, the concept of the index (one of several indices developed by Dow) was formed.

The Dow Jones Industrial Average has been the benchmark for 100 years or so for market followers. The initial use of the index was to track overall market sentiment, and measure the performance of any individual issue (stock) against the overall market. This was done via a direct comparison to the index for a similar period.

The Dow Jones Industrial Average today

The Dow Jones Industrial Average tracks the top 30 stocks. It’s price-weighted and is currently a scaled average.  I won’t bore you with the matrix that makes up the valuation (as it is irrelevant here), but since the divisor is currently less than one, the value of the index is larger than the sum of its component prices.

Initially, Dow devised an index comprised of 9 railroads and 2 industrial companies.  This was the predecessor to the DJIA.  Of those original companies included in the index, the only company to remain today is General Electric.  However, that index was expanded a few short years later to include a total of 30 stocks which make up the index, which is still the case today.  An interesting note, when first published, the value of the Dow Jones Industrial Average was 62.76.  My, how things have changed.

Standard & Poor’s

There are many companies that track stock & commodity prices.  One of those, Standard & Poor’s, introduced its first index in 1923. On March 4, 1957, they came out with the S&P 500, which tracks the price of the top 500 stocks on the NYSE & NASDAQ exchanges. It’s been electronically “calculated” since 1962. Unlike the DJIA, the S&P 500 is a market-cap (capitalization) weighted index.

The S&P was the first successful stock index when it began trading at the Chicago Mercantile Exchange (CME) in 1982. Initially, the S&P was pit traded only. It’s now called the “big” contract, or just the “bigs”. At first, floor traders had to be coerced to spend some time in the S&P “pit” to stimulate trading and generate interest in it as a viable trading vehicle.  The CME distributed “buttons” denoting their plea of “15 minutes please,” which referenced their request to have floor traders spend at least 15 minutes of their trading day in the S&P pit trading the new S&P 500 futures contract.

In 1992, the S&P 500 futures (still just the big contract) became tradable electronically on the Globex electronic platform. In 1997, the CME launched the all electronic, mini-sized (now called the “E-mini) futures contract to be traded over the internet by anyone.

Get a broad measure with S&P

Eventually, the S&P surpassed the DJIA in terms of its importance and relevance, both to investment banks as a hedging vehicle, as well as to all traders as a broader measure of overall market sentiment. This is because it reflects the actual value of the top 500 stocks in its make-up as opposed to just 30 for the DJIA (those same 30 are in the S&P 500 as well).

Back when Charles Dow first came up with the idea of using the top 30 stocks for his index, as we said, there were maybe 100 – 120 publicly traded entities.  Now with over 8,000 stocks (and 40,000+ if you include pink sheet listings), using a 30 stock index is not as advantageous to most traders as using a broader measure, hence the popular use and following of the S&P 500 as the benchmark for the past 20 – 30 years.

Trading indexes

When the push came to make the indices themselves tradable, there was much speculation as to where they would be traded. Since trading or holding any of the index being traded does not represent actual ownership in any of the underlying stocks which comprise that index, they could not have the indices traded on the actual stock exchanges. The logical choice then was to have them traded at the Chicago Mercantile Exchange, where they trade futures contracts. This term which may seem scary, intimidating or somewhat obligatory at first, but for our purposes, it is merely a unit of measure.

Want to learn even more? Check out our Website at www.LeadingEdgeTrading.com to discover what it takes to trade like a pro.

Posted by Ford Saeks on October 29, 2014 in Trading Basics.

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