Stock index: Tool of the trade

Stock index trading on the stock market successfully requires an understanding of the tools available. One of the most important of those tools is a mathematical construction used to describe the stock market called the stock index. It can be used in a number of ways depending on the methods and goals of the stock trader. Someone trading for long term gain will use an index differently from someone trading for short term profit.

Stock-indexStock indices are compiled by selecting certain stocks to represent a section of the stock market so the value can be measured for that particular section. The value is computed based on stock prices, which is usually a weighted average. Indices can't directly be invested in but can be used to select the best stocks to invest in. Some mutual funds select an index and invest in the stocks in that index so it can sometimes appear that the index itself has been invested in.

Stock index classifications

Different stock index classifications of stock weighting exist with two being the most commonly used. These two are price-weighted and capitalization-weighted. Price-weighted is strictly based on the price of each component stock in an index. This weighting means that the price of even one stock changing in price can have a major influence on the value of the index the stock is in regardless of the size of the company. 

This can happen even if the change is considered rather insignificant by itself. With capitalization-weighting, that same change will have a greater influence on the value of the index if the stock is from a larger company than from a smaller one. The other types of weighting are mostly variants and/or combinations of the most common two.

The overall health of the stock market is often measured using one of the largest stock indices. A common stock index for this purpose is the Dow Jones Industrial Average. It is the one that even non-investors are familiar with by name. Investors may use it to know whether they are dealing with a bull or bear market so they can decide whether it is a good time to buy, sell or ride it out.

Indices time period

Long-term investors use the index to see how stocks have done over a long period of time, which can be as short as a few months to as long as over a decade. Long-term investors look for stocks that hold value well and show relatively reliable gains. Many mutual fund investors use stock indices in the same way.

Short-term investors have a different perspective since they are looking for quicker profits. Even among short-term investors, there are differences. Some short-term investors buy and sell based on seasonal gains. The type of stock indices  Day traders, on the other hand, buy and sell based on the price action over the course of one day or sometimes a few days. This required going deeper into what stock indices shows and down into individual stocks.

How you want to invest will determine how you will use a stock index and how deep you will go into the finer details of the index.

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