Hello everyone, in this article, we’re going to explore everything about market indices, which are the main indices, how they’re calculated, and how to trade indices using financial instruments that track their movements. But let’s start from the basics: what is an index in the financial market?

When we organize a set of assets with specific criteria, we can create an index, which provides us with an overview of a particular market. What do I mean? Let’s consider the Dow Jones DJIA index, the most well-known stock index. Why was it created? Because we want to have an idea of how the stock market is performing today: is it going up, down, or sideways?

We don’t want to have to look at each individual company every day to draw a conclusion about whether the market is going up or down, right? So, we look at the chart of the Dow Jones index, which has already calculated all the fluctuations of various blue-chip companies that make up this index and has given us an average. This gives us a benchmark, a reference point to understand the overall market performance. Do you understand now?

Benchmarks provide the measure

How do you know if you’re doing well as a trader or investor? By comparing your performance to some benchmark. If I trade Brazilian stocks, my benchmark will be the Bovespa Index. If I trade US technology stocks, I can use the Nasdaq Index. I can even trade the Nasdaq itself, as I’ll demonstrate in this video on how to trade the world’s largest indices.

Indices are not limited to stocks; they can represent a variety of markets, such as commodity indices. Within these indices, we have the prices of oil, corn, copper, silver, serving as a reference to understand the overall trend of commodities. Or they can also be indices of agricultural commodities only. You can even create your own index, for example, by taking the top 5 altcoins by market capitalization and creating an index using the same calculation as the S&P 500. Do you understand now?

How to build an index

Imagine that the S&P 500 index is this circle {a circle appears}. Inside it, there are 500 companies, such as {MSFT, AAPL, AMZN, NVDA}. The value of the S&P 500 index is calculated by a weighted methodology of free float market capitalization. What does that mean? This calculation first takes the market capitalization of each of the 500 companies that make up the index, multiplying the number of shares in circulation by the current price of the share.

Anyway, what matters is that there are different criteria in the calculation of different market indices, which can be weighted or unweighted indices. I can simply take the top 100 US companies, done, without any other criteria. Or I can take the top 100 US companies excluding the financial sector, which is the Nasdaq100 index. I’ll show you how to trade it shortly.

Another example is the NYSE Composite index, which includes all the stocks on the New York Stock Exchange, without discrimination. Its value is based on the capitalization of all stocks on the exchange. As for the Dow Jones index that we mentioned earlier but I skipped over the calculation, it’s simply a price-weighted average, based on the sum of the quotes of 30 stocks divided by a divisor, and this calculation changes as companies enter and exit the Dow Jones Index.