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:
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.
DJIA (Dow Jones Industrial Average) is a crucial stock market index. It tracks thirty major blue-chip companies (publicly owned) that trade on the NASDAQ and NYSE (New York Stock Exchange). Charles Dow created this index in the mid-1880s with Edward Jones, his longtime business partner. The oldest market index in the United States is the Dow Jones Transportation Average and the DJIA is a close second.
Charles designed this index as a helpful proxy for the overall condition of the United States economy. Many people monitor the DJIA for various blue-chip stocks and consider it a benchmark index.
After initially being used internally, the DJIA index was first published in 1896 and only had twelve components, most of them from the industrial sector, including tobacco, sugar, gas, cotton, and railroad industries.
During the early twentieth century, the economy’s overall growth rate had a direct relation with how industrial companies were performing. Although there are few heavy industry components remaining in the index today, that relationship still continues as most investors look at Dow performance to gauge whether or not the economy is strong.
NASDAQ (National Association of Securities Dealers Automated Quotations) is an American stock exchange that came into existence in 1971 as an alternative to the transaction system for stocks which was present during that period. It is the most significant electronic stock market and second-biggest stock exchange based on market capitalization
The NASDAQ 100 Index itself is made up of securities issued by 100 non-financial companies listed on the NASDAQ exchange.
Components are from a variety of industries, including transportation, industrial, biotech, retail, healthcare & media. However, most people associate the index for its hi-tech stocks weighting, including the ‘FAANG’ stocks (Facebook, Apple, Amazon, Netflix & Google Alphabet).
S&P 500 Stock Composite Index made its debut on the 4th of March, 1957. It measures the performance of the 500 largest listed companies in the USA and as such is a very good index to measure the performance of the USA stock market.
How are each of these Indices calculated?
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.
What is the difference between them?
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.