A market index is a basket of securities that is intended to represent the value of some specified market or market sector. Investors and financial professionals can then use this representative index to gauge the overall state of that market or market sector.
One of the most widely-known examples of a market index is the S&P 500, which is intended to be representative of the whole of the U.S. equity market.
Contemporary Markets and the Market Index
The use of market indexes is actually quite old. The oldest known market index being the famous Dow Jones Industrial Average (DJIA), which was composed as an average of 12 major industrial equities and is known as a composite index.
It is natural for people to attempt to create a simpler yet effective image of the overall market or some sector of the market, so the emergence of market indexes was a predictable result of the growing interest in the stock market.
The growing influence of computers in finance has allowed the use of market indexes to flourish, and their effectiveness has increased correspondingly as computers allow ever more accurate and specific formulations.
There are now a large number of market indexes in use, both broad and specific, and these indexes use extremely complex weighting formulas, as computers are able to keep pace with the constant changes in the prices of the composite securities that make up the market indexes.
It is common for investors and financial professionals to talk about market performance in terms of market index activity, and contemporary market indexes have led to an explosive growth in related financial instruments.
Trading with Market Indexes
Day traders can use market indexes both as a tool for evaluating market performance and as a direct investment through the use of exchange-traded funds (ETFs) that track market indexes or futures and options contracts that are based on market indexes.
A market index provides day traders with a very effective means of gauging the overall activity of the markets that they intend to trade in.
Many of the securities in a market or market sector tend to rise and fall in tandem, as the circumstances that affect one security are likely to affect other securities at a rate that is commensurate with how similar the securities are to one another.
Even a good trade setup on a single security can be a poor call if the overall market or market sector is moving in the opposite direction. By contrast, when the market or market sector is moving with a trade it can provide an added layer of safety and profit to an already positive trade.
ETFs and derivatives products based on market indexes are very popular securities in the contemporary financial markets.
These products allow day traders to make directional trades on the overall market or market sectors, which can be just as lucrative as any other area of day trading.
This type of trading has its own unique advantages and drawbacks, just like any other area, but appeals to day traders who like to maintain a strong macro view of the financial markets.
This can make for interesting trading that is based more on reacting to the constant flow of relevant information, as opposed to looking at technical responses to recent price action.
The idea of the market index is almost as old as modern stock markets. The market index is a natural extension of the growing popularity of the financial markets, as people tend to try to simplify large amounts of complex information into something more manageable.
Day traders can use market indexes both to track overall market performance and as a source of related financial instruments.
However, traders should be careful to understand how any market index that they intend to trade on is constructed.
Some market indexes have odd rules that can lead to sudden shifts in value that are unrelated or only partially-related to the performance of the securities that it is based on.
That said, in general market indexes and financial products based on market indexes are very popular among a wide range of trader and investor types.