A composite index is essentially a group of stocks that are averaged together in order to provide an overall view of a specific sector or industry.
The word composite basically means a blend or combination of many things to form one big picture thing. A composite hockey stick just means that it’s made of a combination of different materials like fiberglass and aluminum.
The same is true for composite indexes–they combine data from multiple securities intending to give you a big-picture view of the stock market.
The Dow Jones Industrial Average is a composite index. What makes that so? Because the Dow combines thirty of the world’s largest companies and averages them together to give us one easy data point by which to gauge the performance of the stock market.
In the case of the Dow, the index is price-weighted, meaning a stock’s weight in the index is determined by how expensive one share of the stock is. For example, Apple (which is currently trading at around $280) has more influence on the index’s calculation than Pfizer (which is currently trading at approximately $40).
Each composite index has its methodology by which to weight the components. For example, the MSCI USA Equal Weighted Index weighs all of its components equally, while the S&P 500 weights it’s 500 components based on their market capitalization.
Composite Index Weightings
In the creation of a composite index, the decision of component weighting is as crucial as the decision of which components to include.
The popular weighting methods are as follows:
- Market Cap Weighted: Used for an index only composed of companies. The larger a company’s market cap, the more weight it holds in the index.
- Price Weighted: Largely viewed as an arbitrary and outdated weighting method. The higher a security’s per-share or per-contract price, the more weight it holds in the index.
- Fundamental Weighted: Only gained prominence in recent decades with the advent of “smart beta.” A company’s weight in the index is determined by a metric like sales, cash flow, or earnings. An example of a fundamentally weighted index is
- Equal Weighted: Every component is weighted equally, regardless of other factors.
Why Use a Composite Index?
A composite index makes things easy for traders. The majority of WT’s readership doesn’t trade the top Dow or S&P 500 components, making analyzing each company’s chart impractical. All we need to know is how the broad market is doing, as the broad market’s performance will trickle-down to the momentum stocks we trade.
Many traders will use several composite indexes in conjunction with each other to form a view on the entire market. Many of these exist for both the intraday and intraday time frames, but let’s take a look at some intraday composite indexes.
Almost all of us are familiar with the popular composite indexes like the Dow Jones Industrial Average, S&P 500, and Nasdaq 100, but there are thousands of indexes, all serving their purpose.
The S&P 500 Volatility Index, better known as the VIX, is also a composite index. The index looks at the pricing of various SPX options to form its calculation of the index, which aims to project the implied volatility of the S&P 500 for the next 30 days.
More examples of composite indexes:
- Composite Index of Leading Indicators: a composition of 10 macroeconomic indicators historically shown to lead to economic changes.
- NYSE Advance-Decline Index: Outputs a net reading of how many stocks are advancing or declining during a trading session.
- Dow Jones US Technology Index: composed of top US-based technology companies, weighted by market cap
History of the Composite Index
The Dow Jones Industrial Average was created by the founder of the Wall Street Journal and Dow Jones & Company, Charles Dow in 1896.
Dow created the index for two reasons because indexing the major stock market components became a cornerstone of his trading approach. Dow realized that the larger companies moved in tandem, and if you were able to form a thesis on the entire market, that would make it infinitely easier to pick individual stocks.
In developing the index, Dow realized its utility for readers of the Wall Street Journal as a gauge for the performance of the stock market as a whole. Dow’s work on indexing laid the groundwork for the quick, big-picture market analysis you still read in major financial media today.
Dow’s work lead to the proliferation of the composite index, with thousands of indexes used to gauge the general trend of a market sprouting up over the following decades.
Between regular stock indexes like the S&P 500 and market internals like the NYSE $TICK index, you probably use several composite indexes in your trading each day. Think about how difficult it would be to replicate the thin-slice analysis you get from looking at a basket of indexes.
On one screen, you can have a chart of the VIX, S&P 500, Advance-Decline Index, and volume breadth and have a deep understanding of what is driving the market during a given trading session.