A stock index is derived from a reference portfolio of stocks that is deemed to best represent a particular geographical market or market sector. Most major economies as well as developing economies have at least one financial stock index to represent their national portfolio of exchange traded stocks.
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The most famous index is American Dow Jones Industrial Average (DJIA) which is comprised of the stocks of the 30 largest companies in the United States. The DJIA is commonly used as a proxy by investors to represent the condition of US stock market as a whole.
The value of an index is usually described in terms of a number of points, with its’ value generally representing a weighted average of the current prices of its component stocks. This means that the changing value of an index from one day to the next reflects the fluctuating values of the individual stocks that it is made up of, and is why an index can be a good representation of the state of a country’s economy or of a specific industry.
To trade indices, traders can go long on a particular index if they believe that the stocks traded on that index’s respective market are likely to increase on an overall basis in the future, or go short on an index if they predict that said stocks will fall in value on an overall basis. Understanding the stocks that make up an index can be an effective way of analysing an index In addition, different indices can have a particular focus on certain types of stocks by industry or market sectors. For example, the NASDAQ index mostly consists of technology stocks and so can generally be seen as a measure of the performance of the technology industry in particular. Monitoring indexes and noting their movements over time can help inform traders about investors’ attitudes towards a range of companies and market sectors.