Which best describes what a market index does? This was a question posed by a new client last weekend during one of our webinars. Index’s are all the buzz lately as people are incredibly bullish on the market. Rather than picking stocks, these individuals are so bullish on the market that they just want exposure to the whole market. Because of this, they buy indexes.
We don’t think this is the best way to trade and invest in indexes however and completely disagree with all of a sudden becoming very bullish at all time highs. There are ways to get exposure to these market indexes that we will talk about here when we answer the question “which best describes what a market index does?”.
What is a Market Index?
A market index is a basket of stocks that give a representation of a larger group. Let’s look at an example.
The FTSE 100 (Financial Times Stock Exchange) is a market index that is comprised of the 100 largest companies traded on the London Stock Exchange. This market index of 100 was created to give an overall view of how the stocks on the London Stock Exchange are trading. Investors can look at the FTSE 100 and get a gauge of how the London market is doing as well be able to invest in the market index to have overall exposure to the London market.
Market indexes are a draw for investors as they can provide a “diversified” way to get exposure to whatever the index represents. There are four main market indexes in the United States.
US Market Indexes
The four market indexes that trade in the US are:
- S&P 500 – a basket of 500 stocks that gives the best representation of the status of the US equity markets. This is the index that every professional trader watches all day.
- Dow Jones Industrial Average – a basket of 30 large cap stocks in many different sectors including industrials, energy, and banking. The Dow used to be the most watched index but the companies that currently make up the Dow are 30 large cap stocks that are not growth stocks.
- Nasdaq – a basket of 3,100 stocks primarily in the technology and the biotech space. The Nasdaq is also an exchange and is the second largest exchange in the world behind the New York Stock Exchange.
- The Russell 2000 – a basket of 2000 mid to small cap primarily US based companies.
How to Trade These Market Indexes
All of these indexes are cash settled. This means that we are unable to trade stock in the actual Dow Jones Industrial Average Index ($DJX), the S&P 500 Index ($SPX), the Nasdaq Index ($NDX), and the Russell 2000 Index ($RUT). This means that we can only trade options in these indexes and these options rather than settling to stock settle to cash. Hence cash settled.
However, each of these indexes has an ETF that allows for the exact same exposure to these market indexes with crazy high volume and a ton of liquidity. These ETF’s are:
- S&P 500 ETF – $SPY
- Dow Jones Industrial Average ETF – $DIA
- Nasdaq ETF – $QQQ
- Russell 2000 ETF – $IWM
If you want exposure to these market indexes and the baskets of stocks that each represent, trade these ETF’s.
Which Best Describes What a Market Index Does?
It gives investors two things:
- A snapshot of the overall market
- A way to get exposure to a larger sector
However, we never trade those indexes themselves, we trade their ETF’s.