As you probably already know, Stock price fluctuation is common. Sometimes these changes are frequent and quick, while on other occasions, they happen randomly and can catch you off-guard. However, if you have the right knowledge and experience, you can tackle these problems by understanding and gauging the stock market’s overall health. This separates professional investors from inexperienced ones.
If you are new to the stock market and want to familiarise yourself with its ins and outs, you must understand some essential market indices which will help you quickly assess market performance.
While there is a long list of these indices, there are three that every aspiring trader should understand. They are:
- Dow Jones Industrial Average
- S&P 500
So, how you can interpret market movements through these indices? Well, let us understand market mechanics by breaking down each of these vital indices, taking a closer look at what makes them different, the similarities between them and how they can help traders.
Dow Jones is calculated by taking the sum of prices of the 30 stocks that make up the index and this figure is then divided by the “divisor.” It takes elements like stock mergers and splits into consideration, which are vital components responsible for making a scaled average in Dow. Not calculating Dow as a scaled average would cause the index to decrease if a stock split occurred.
A popular technique known as the market capitalization weighting method is used to calculate NASDAQ. You have to take the overall value of every stock’s share weight and multiply the amount with the closing price of each security. It is then divided by an index divisor.
S&P 500 is calculated by taking every company’s outstanding shares and multiplying it by their current market value or share price. Also, since the S&P 500 is a free-floating capitalization weighted index, it only includes publicly available shares.
While these U.S indices have a close correlation, they have distinct qualities because of their unique makeup. S&P 500 has a high number of stocks associated with it, which is why it does not usually face a significant impact from fluctuations on a single day.
Dow Jones on the other hand, only has thirty stocks. Therefore, stock performance can cause a massive impact on it’s price. At present, the ten stocks with the highest contribution in the index are responsible for more than fifty percent of Dow's overall value, which shows how individual stock performance can make or break this index.
NASDAQ is broader compared to Dow, considering its plethora of components. Despite that, the impact caused by smaller groups is still noticeable. The ten stocks with the highest contribution in the index account for more than fifty percent of NASDAQ's value, so price swings on few stocks are enough to create problems for NASDAQ traders.