Essentials Of 'Indices'

[timsk]

Update 7th March, 2022: The Essentials of Trading series has now been retired. A big thanks to timsk for all his efforts with this initiative. These threads will no longer by stuck to the top of forums, but will still be available for members to view. We decided to retire them because they are no longer being actively updated.

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Welcome to the Essentials of Indices Sticky. ‘Essentials’ Stickies are threads that are ‘stuck’ to the top of a forum index. They contain information about the forum you’re in that is of critical or ongoing value - hence the ‘Essentials’ name. If there’s anything missing from this Sticky that you hoped or expected to find, please contact timsk, T2W Content Manager and, if at all possible, it will be added.

What are Indices? - See Post #2
This section of the Sticky looks at the origin of indices, their construction and also explains something that confuses many new traders – how the ‘futures’ index and ‘cash’ index relate to one another. Understanding this relationship is especially important if you want to trade instruments based on cash indices or their constituent stocks.

T2W Indices Tips & Tools - see Post #3
This section of the Sticky lists the financial centres with links to their exchanges, followed by their respective indices and a short glossary.

Other Resources on T2W & Beyond - See Post #4
Listed here are some great resources that you’ll find beyond the walls of this forum in the Articles section, Videos section and on other websites. Each item has a short précis and a direct link.

 

[timsk]

What are Indices?

In the context of trading and investing, the most common indices are market indices which measure the change in value of tradable instruments such as stocks and bonds, relative to a base value – which is usually time. This can be months, weeks, days or even intra-day. Traditionally, their use is as a benchmark to gauge the performance of other investment vehicles such as mutual funds or investment trusts. For traders, who tend to be focused on shorter timeframes, indices offer an insight into market sentiment, either at a world or global level (e.g. S&P Global 100) or national level (e.g. FTSE 100). Beyond this, there are specialist indices which focus on a specific sector of the market (e.g. PHLX Semiconductor Sector SOX). Each can act as an invaluable bellwether to aid trading decisions. For example, if the main market index is very bullish, some stock traders will not take short positions, regardless of how weak an individual stock may be – the result of an adverse news announcement perhaps, or because of poor trading figures or a broker downgrade etc. An expression attributed to John F. Kennedy, ‘a rising tide floats all ships’, is a popular one amongst many stock traders.

HOW IT ALL STARTED
Besides stock market indices, there are a myriad of other indices and, in the coming years, it’s likely that new ones will emerge that are useful to traders. For example, the internet giant Google produces a collection of domestic trends indices, based on search traffic. These days, if we’re job hunting, we tend to search for vacancies online. Ditto when we’re house hunting or researching the best insurance deal. In fact, increasingly, we do more and more searches online before taking action, be it applying for a job, viewing a property or taking out a million pounds worth of life insurance for our aging battle axe of a mother-in-law. Google trends provide a window into the future because there is a direct correlation between online searches done today - and future employment figures, house sales or insurance revenues – to use the examples provided. The bad news for traders is that exploiting this information for profit is probably a little harder than one might imagine. Why? Well, the answer to this question was provided over one hundred years ago by the man who created the world’s first known stock market index, Charles Henry Dow.

Charles Dow – he of Dow Jones fame - is the indisputable father of the modern stock market index. In 1882, he and two partners: fellow financial reporter Edward Jones and Charles Berstresser, formed Dow, Jones & Co., in the basement beneath a sweet shop in Wall Street. They published a subscription based newsletter which was well respected for providing unbiased and independent research about companies and their future prospects. The fledgling company grew quickly and, by 1889, they employed over fifty people. The time was right to turn the two page newsletter into what would become one of the best known financial publications in the world - the Wall Street Journal (WSJ). Today, the WSJ is the largest daily newspaper in the U.S., employing over 2,000 journalists, reporting from 58 countries.

The first index that Dow created was published on 3rd July 1884 in ‘The Customer’s Afternoon Letter’ – the two page newsletter which was the precursor to the WSJ. At the time, there was no better barometer of the economy than the railroad stocks which were the growth stocks of the day and among the most heavily traded companies on the New York Stock Exchange (NYSE). Dow chose nine of them to form the basis of his ‘Rail’ index, plus a steamship line and Western Union - a communications company. Over time, the index grew to twenty constituents and later evolved into what is now known as the Dow Jones Transportation Average (DJTA).

The WSJ was well established by the time Charles Dow created his second and most famous index: the Dow Jones Industrial Average (DJIA). It was first published on the 26th May 1896 and differed from the rail index to reflect a broader cross section of the market. It comprised twelve companies and, of these, there is one that’s still going strong today and, furthermore, is still a constituent of today’s DJIA. That company is General Electric.

Between 1900 and 1902, Dow published a series of articles in which he formulated what is known as ‘Dow Theory’. To this day, Dow Theory remains at the heart of modern technical analysis (TA). The theory centres around six basic assumptions about the market. With one exception, these won’t be discussed here although, if you want more information on this topic, then there are links in the ‘Other Resources on T2W & Beyond’ section of this Sticky. The exception is the first and, arguably, the most important premise of Dow Theory, which states that ‘the market (price) discounts everything’. In other words, all past, current and even some future information is accounted for in the latest price of an individual instrument or stock market index – such as the DJIA. If Charles Dow were alive today, he would probably be fascinated by Google Trends indices. But, because of the first premise of his theory, he would not be rubbing his hands together with glee, or jumping up and down with excitement, in anticipation of being able to front-run the market. His belief would be that the market already discounts Google Trends and that profiting from this apparent ‘window into the future’ will not be quite as straightforward as less savvy market speculators might imagine or hope that it will be.

Charles Dow died in 1902 aged just 52. His legacy to traders and investors the world over cannot be underestimated. Interestingly, at the time of his death, technical analysis was in its infancy and he would not have known about the two schools of thought that would emerge over the coming decades, with investors seeking to profit from the use of fundamental analysis on one hand, and traders seeking to profit from technical analysis on the other. However, what might have tickled him is the knowledge that these two camps, so often poles apart ideologically, both have recourse to the market indices that he created. Market indices like the DJIA are the common denominators that unite all traders and investors the world over. Many of the rules for profiting from the markets that he advocated in the WSJ are as applicable today as they were then, both to long term investors and short term traders alike. One wonders how often this timeless observation has been reproduced in books, magazines and on forums such as T2W:
“The public, as a whole, buys at the wrong time and sells at the wrong time. The average operator, when he sees two or three points profit, takes it; but, if a stock goes against him two or three points, he holds on waiting for the price to recover, with oftentimes, the result of seeing a loss of two or three points run into a loss of ten points.”

Charles Henry Dow, 1851 – 1902​

INDICES AND THEIR CONSTRUCTION – A VERY WEIGHTY SUBJECT
The first and most important thing to realise about indices is that they are not all calculated in the same way. When Charles Dow created the DJIA back in 1896, the calculation he used was a simple average arrived at by adding the prices of the twelve constituents and dividing the total by - you guessed it – twelve! Today’s version of his index is calculated slightly differently. Instead of just twelve stocks, it lists thirty ‘blue chip’ companies. The influence - or weight - exerted by any one of them - is governed by its price relative to the prices of other stocks in the index. For example, if stock A is trading at $100 and stock B is trading at $10, then stock A accounts for 10 times more of the index value than stock B does. Critics of this system of weighting argue that the $100 stock could be a younger and less well established company than the $10 stock and that, more importantly, the more expensive stock might actually be a smaller company than the lower priced one.

Price weighted indices are less common than indices weighted according to market capitalisation. In this second category, the bigger the company, the greater the impact it will have on the index, regardless of its share price. So, for example, in the FTSE 100 - which is calculated this way - a 1% move by HSBC Holdings with a market cap’ of £116,734 million will have a much larger effect on the index as a whole than a 1% move by a (relatively) small company like Rangold Resources with a market cap’ of a mere £4,426 million. If HSBC so much as sneezes, all the other 99 companies in the index catch a cold. Whereas, if Rangold catches flu, no one else really notices. If the FTSE 100 was price weighted in the way that the DJIA is, then the story would be very different. At the time of writing, HSBC is trading at around £6.70p per share. By stark contrast, Rangold is trading at around £49.00 per share. By market capitalisation, Rangold is only 3.79% the size of HSBC, yet its share price is over seven times as big. Critics of indices weighted by market cap’ argue that it’s conceivable (although – to be fair - not very likely), that on any one day the FTSE100 could close up, printing a bullish candle on account of HSBC, Shell, BP and Vodafone etc. having a good day, while the other ninety or so stocks in the index all have a bad day and close lower. Such is the power of stocks with a large market cap’. There are other ways of calculating and weighting indices, but the market capitalisation method is the most common. In addition to the FTSE 100, the following indices are all calculated in this way: Nasdaq 100, Nasdaq Composite, NYSE Composite, Hang Seng, S&P 100, S&P 500, Russell 2000, IBEX 35 and CAC 40.

CASH & FUTURES
In themselves, indices are not tradable instruments. So, if you want to invest in them, you’ll have to do so via a mutual fund or Exchange Traded Fund (ETF) that’s based on the index. Traders wanting to do the same thing over shorter timeframes will have to turn to ‘derivatives’, so called because they are tradable instruments that are ‘derived’ from the underlying index, often referred to simply as the ‘underlying’. Spread Betting, Contracts for Difference (CFDs), Options and Covered Warrants are all examples of derivative vehicles that enable traders to speculate on the movement of indices like the DJIA and FTSE 100. Increasingly, spread betting and CFD companies offer instruments based on the cash index. However, historically, most of them started out by offering instruments based on the index futures - which themselves are also tradable derivatives – and not the cash index. So, in a sense, the futures instruments offered by these companies are derivatives of derivatives! The relationship between the futures index and the ‘underlying’ cash index is what we’ll cover next.

Please refer to the ‘Essentials Of Futures’ Sticky for a more detailed look at what futures are and who trades them and why. The values of index futures are different to their cash counterparts for a number of reasons, the main ones being the ‘Cost of Carry’ and ‘Fair Value’. These are best explained in a quote from the FAQ section of CapitalSpreads’ website in answer to the question: ‘How are daily FTSE and Wall Street prices calculated?’

“All major indices quoted by Capital Spreads have a futures market related to them (i.e. the FTSE 100 has the LIFFE FTSE Futures market). This future trades at a price which reflects the underlying market plus some adjustments. These adjustments are calculated from the theoretical value of dividends payable between today and the expiry date of the future AND the ‘cost of carry’ for the index over the same period.

This Adjustment is called 'Fair Value'. Capital Spreads will adjust the Daily Cash price of each index by its own Fair Value number each day. Capital Spreads links the Rolling Daily quote to the relevant future concerned and offsets the quote by the current Fair Value. Therefore the Rolling Daily price is moved by the Futures price and not vice versa, this is because the underlying cash price is a lagging market indicator which does not react in a timely manner to market moving news.”

The final sentence is emphasised in bold primarily for the benefit of new traders who wish to focus on instruments offered by spread betting companies that are intended to mirror the cash indices. Anyone who attempts to trade these instruments without taking the futures into account and understanding how the futures impacts the cash market is, in effect, trading with one eye shut!

Broadly speaking then, fair value is equal to the cash index price after taking into account compounded interest (and dividends lost because the trader/investor owns the futures contract rather than the physical stocks) over a certain period of time. This makes fair value a moveable feast; not least because the dividend payments you might have received (had you owned the underlying stocks in the cash index) are not cast in stone. Some companies announce their future dividend payments in advance – and even stick to them – while others don’t. So, although the cash and futures indices are highly correlated, they can get out of synch. When this happens, computer ‘arbitrage’ algorithms will quickly spot any discrepancies and short the futures if they have moved too far away from the cash index, or go long if they have moved too close to it. (For anyone wanting greater clarification on the relationship between cash indices and their futures counterpart, please see the links provided in ‘Other Resources on T2W & Beyond’ - post #4.)

 

[timsk]

T2W Indices Tips & Tools

INTRODUCTION
The format of the ‘Tips & Tools’ section shown here is replicated in six other ‘Essentials’ Stickies: Essentials Of ‘First Steps’, Essentials Of ‘Forex Discussion’, Essentials Of ‘Options’, Essentials Of ‘Trading Software’, Essentials Of ‘Data Feeds’ and Essentials Of ‘Techies Corner’. The idea is to explore the forum subject in greater depth than is necessary in forums that don’t have a ‘Tips & Tools’ section.

Listed here are the major world financial centres, as well as links to the major exchanges, followed by their respective indices and a short glossary. The first section of this Sticky, ‘What are Indices?’, emphasised the importance of understanding the number and type of stocks in an index, as well as the way in which it's calculated. This is important as it can skew the ‘message’ being conveyed. For example, it doesn’t necessarily follow that all - or even the majority - of stocks listed in an index weighted by market capitalisation will close higher, just because the index itself closes higher. It’s entirely possible for half or even three quarters of them to close lower, while the index as a whole closes higher. The mantra of this forum then is ‘know thy index and how it’s calculated’! It’s also worth noting here that this is quite simply a guide to each index, and not a guide to trading them.

OVERVIEW
Standard and Poor's and Morgan Stanley are known as the world leaders in the production of economic data, which is used throughout the world's financial markets. In late 1999 the two organisations came together to provide an industry standard classification system known as the Global Industry Classification Standard, or GICS.

There are literally hundreds of thousands of indices covering any company in any sector or industry you care to imagine, and it is not the intention to discuss these here. What we will concentrate on however, are the main indices which relate to the respective financial exchanges, plus a number of the more commonly referred to indices you might encounter in your trading.

QUICK REFERENCE
The list below provides links to exchanges in the main financial centres of the world.
LONDON
The London Stock Exchange (LSE) is the oldest stock exchange in the world, listing around 3000 companies.
NEW YORK
The New York Stock Exchange (NYSE) is the largest stock exchange in the world by dollar volume with over 2500 listed securities. NYSE is operated by NYSE Euronext, the holding company created by the combination of NYSE Group, Inc. and Euronext N.V. NYSE is a world leader for listings, trading in cash equities, equity and interest rate derivatives, bonds and the distribution of market data.
CHICAGO
FRANKFURT
TOKYO
The Tokyo Stock Exchange (TSE) is the second largest stock exchange market in the world by market value. Lists 2,271 domestic companies and 31 foreign companies, with a total market capitalization of over USD $5 trillion.
EUROPE
STDNEY
WELLINGTON

THE INDICES
Because there are numerous indices around the world, here on T2W, there are four sub-forums within the main Indices forum, in which specific indices are discussed: US Indices for the Dow, Nasdaq and S&P etc., UK Indices for the FTSE, European Indices for the DAX and CAC etc. and Asia-Pacific Indices for the Hang Seng and Nikkei etc. Below is a description of some of the best known and most commonly traded indices.

The FTSE
Also known as the Footsie, it's official title is Financial Times Stock Exchange Index. There are too many to mention, but the main ones of interest would be the FTSE100, FTSE250 and FTSE All-Share. The one referred to most by traders is the good old Footsie 100, which reflects the value of the top 100 companies listed on the London Stock exchange as valued by market capitalisation.

In trading terms, people either trade FTSE futures, futures options, or related instruments produced by Spread Betting (SB) companies that are derived from either the cash index or the futures.
For more info': FTSE

The DJIA
The Dow Jones Industrial Average is commonly referred to simply as ‘the Dow’. As the name suggests, it is not an index at all, it’s an average. First created by Charles Dow in 1896, it was originally made up of twelve stocks, through the years this became twenty, and now consists of thirty of the top US ‘blue chip’ companies. Unlike the FTSE100, it is a price weighted index and the total value of the stocks is ‘averaged’ using a mathematical formula. It’s the best known of the US indices, but far from the most important, due to the obviously small representation of the whole market.

Traders will use futures – e.g. the YM e-mini contract traded on the Chicago Board of Trade (CBoT), futures options or, again, a SB derived instrument based on either on the cash index or the futures index.
For more info': DOW

The S&P 500
Commonly known as the Spooz, and widely regarded as the benchmark index which reflects the overall sentiment of the US market. It consists of a representative sample of 500 leading companies in the main industrial sectors of the market. With a history that dates back to 1923, the index as it stands today was established in 1957 when it was increased from 223 companies up to the present figure of 500.
For more info': S&P

Related indices are the Chicago Board of Options Exchange (CBOE), Volatility Index, known as the VIX - which is a measure of expected market volatility and the S&P Banking Index, known as the BIX - touted by many as a useful indicator of the overall S&P500.

Traders can choose futures, futures options, SPY - the Exchange Traded Fund (ETF), SB companies or the baby brother of the Spooz which is the E-mini S&P500, commonly known as ES. This is the exclusively electronically traded instrument available via the Globex Exchange, and is perhaps the most widely traded futures instrument in the world.

The Nasdaq
The Nasdaq Composite index is the best known technical index in the world. Sometimes referred to as the ‘Comp, it contains all stocks listed on the exchange, which is currently over 4000. The Index was born in July 1984 at a base level of 100! The Nasdaq 100 is another well known index of the exchange which represents 100 of the largest non-financial companies listed on the exchange based on weighted market capitalisation. Another Nasdaq related index is the Phillips Semi-conductor Index, also known as the SOX. This is highly regarded as a useful indicator of overall market sentiment.

This market can easily be traded through the Exchange Traded Fund QQQ, commonly referred to as The "Cubes", which tracks the Nasdaq100 index. Alternatively traders can use futures contracts, options or the well known SB derivative contracts.
For more info': NASDAQ

The Dax
The Dax reflects the German blue chip segment comprising the largest and most actively traded German companies that are listed on the Frankfurt Stock Exchange. It was established as the benchmark German index in 1959 when it took over from the Borsen-Zeitung Index. Only the publicly available or "free float" stock issued is taken into account when assessing companies for inclusion in the index. Mainly traded through futures and via the usual SB company instruments.
For more info': DAX

The Eurostoxx 50
This is the index prepared by Dow Jones & Co. which represents 50 of the top companies traded on the Eurex Exchange. These are only companies from Continental Europe and so exclude UK companies. Nokia is a market heavyweight in this index and, as a result, any activity related to this stock has a direct impact on the whole index.
Mainly traded via futures contracts.
For more info': EUREX

The Nikkei 225
The Nikkei 225 Stock Average is like the Dow in not being a true ‘index’. The value is calculated as the summation of the values of 225 blue chip companies listed on the Tokyo Stock Exchange, divided by a numerical divisor.
Again, tradable via futures, futures options and through the various SB company instruments.
For more info': NIKKEI

The Hang Seng
The leading index of the Hong Kong Exchange. It is weighted by the market cap’ of the 33 largest companies listed on the exchange. As such, it is dominated by the largest company on the market, which is HSBC. As a result of this the futures contract has a much greater volatility than other instruments.
For more info': HANG SENG

The CAC 40
The index which represents the performance of the Paris Borse as a reflection of the value of the top 40 companies of the French Exchange.
For more info': CAC 40

The ASX200
This is generally accepted as the benchmark index for the Australian Stock Exchange. It's official title is the S&P/ASX200, and is the index as calculated by Standard and Poor's to represent the value of the top 200 companies listed on the exchange. This index represented approximately 78% of the total market capitalisation of the exchange as of April 2010, making it one of the most representative of all the global indices.
Tradable via futures and SB instruments such as CMC’s Aussie 200 contract.
For more info': ASX

The NZSX 50
I had to give it a mention, despite being the minnow of all of them!
Comprised of the top 50 companies as listed on the NZ Exchange by free-float market capitalisation. The NZX50 took over from the NZSE40 in March 2003, and is unique in the respect that it takes into account dividends payable by the constituent companies. This is due to the fact that dividends payable are somewhat higher than is the norm in other markets. This index is dominated by one or two heavyweights, most notably Telecom New Zealand.

Not easily tradable, unless you're interested in CMC’s contrived instrument which reflects the top 10 companies!
For more info': NYZ

GLOSSARY
AMEX
The American Exchange

ASX
Australian Stock Exchange

Borse
European name for Exchange

CBOE
Chicago Board of Options Exchange

CBoT
Chicago Board of Trade

CME
Chicago Mercantile Exchange

LIFFE
London International Financial Futures and Options Exchange

LME
London Metal Exchange

LSE
London Stock Exchange

Nasdaq
National Association of Securities Dealers Automated Quotation system

NYSE
New York Stock Exchange

NZX
New Zealand Stock Exchange

 

[timsk]

Other Resources On T2W & Beyond

Listed below are some great resources that you’ll find beyond the virtual walls of the Indices forum.

BOOKS
Options, Futures and Other Derivatives
By John C. Hull / Published by Prentice Hall / Price: USD$ 30.00 – 150.00 or more!
This is a well regarded introduction to the derivatives markets. There are numerous editions of the work - hardback, soft cover and workbooks complete with CDs etc. – with prices that fluctuate wildly.

ARTICLES
By clicking on the red menu tab entitled ‘Articles’ at the top of the page, you’ll find lots of great articles, many of which are written by internationally renowned experts in their field. To access them, once you’re in the Articles section, just click on the ‘Indices’ link found under ‘Markets’ in the Topics panel on the left of the page. Here are a couple to whet your appetite . . .

How the Dow Theory Can Help You Understand Market Movements
A solid introduction to Dow theory with simple charts to illustrate the points made.

The Dow Theory: A History
Another article outlining the basic principles of Dow theory and the men who have shaped it over the years.

Day Trading the Dow Jones
Martin Shoebridge (a.k.a. ‘Chartman’ on T2W) was a very popular member in the early days of the site. This golden oldie article provides insight into his strategy which helped to shape the trading lives of many T2W members. If you enjoy this article, then this thread is likely to appeal to you as well: Trading the Dow Summary

Fibonacci Retracements on the Mini Dow
In this article, Nick McDonald explains how to use Fib’ retracements to trade the e-mini Dow futures contract.

VIDEOS
Cost of Carry Model to Price Forwards & Futures
Good explanation of the ‘Cost of Carry’ model which helps to explain the price of index futures relative to the price of the underlying cash index.

WEBSITES
Google Trends Predict the Present
Steven Levitt, co-author of the best sellers ‘Freakonomics’ and ‘Super Freakonomics’ comments on Google trends, including a link to a Google research paper.

Allstocks.com
A clear and comprehensive explanation of ‘Fair Value'.

StockCharts.com – Chart School
A good introduction to Dow Theory, complete with well annotated charts.

If you know of any resources either here on T2W or beyond that would be of interest and value to members who want to learn more about indices, please contact timsk, T2W Content Manager and, if at all possible, they will be added.

 

[prajktapimpale]

Index Futures:​

Index futures, like all futures contracts, give the trader or investor the power and obligation to deliver the cash value of the contract based on an underlying index at a specified future date. Unless the contract is unwound before expiration through an offsetting trade, the trader is obligated to deliver the cash value on expiry.

An index tracks the price of an asset or group of assets. Index futures are derivatives, meaning they are derived from an underlying asset—the index. Traders use these products to exchange various instruments including equities, commodities and currencies. For example, the S&P 500 Index tracks the stock prices of 500 of the largest companies traded in the United States.1 An investor could buy or sell index futures on the S&P 500 to speculate on the appreciation or depreciation of the index.


Indices: An index is an indicator or measure of something. In finance, it typically refers to a statistical measure of change in a securities market. In the case of financial markets, stock and bond market indexes consist of a hypothetical portfolio of securities representing a particular market or a segment of it.