What is a Stock Market Index and How Does it Work?
What is a Stock Market Index?
When investors refer to the "overall" stock market, they may refer to a specific index. Some stock indices group stocks by market cap or total market value, while others combine market cap and specific market sectors. When you invest in an individual company’s common stock, there is a good chance that it may be part of a stock index.
A stock index can inform investors about the market's overall performance, so the next time you watch the news or hear someone quote a specific index rising or falling, you will know what types of stocks may have been affected. That said, it is important to mention that when a stock index rises or falls, it does not automatically mean that all the stocks that make up the index are up or down.
Only a company's common stock makes up a stock index, and the index itself cannot be bought or sold. For this reason, many traders and investors utilize the stock index options market to trade around the index price. These options are typically cash-settled since there is no stock to associate with the options contract. Learn more about options here.
Finally, ETFs (Exchange Traded Funds) are not included in stock indices. Investors seeking direct exposure to a specific stock index can consider investing in an index ETF that tracks it.
Major US Stock Market Indices
- S&P 500 (Standard & Poor’s 500) – SPX
- Nasdaq Composite and Nasdaq 100 – NDX
- Dow Jones Industrial Average (DJIA) – DJX
- Russell 2000 – RUT
1. S&P 500 (Standard & Poor's 500) – SPX
- The S&P 500 is known as the benchmark for stock market performance
- SPX & SPY are popular products that track the S&P 500
- SPX & XSP are cash-settled indices with no shares of stock, whereas SPY is an ETF where shares can be traded
When investors talk about the "market," they are typically referencing the S&P 500. S&P gets its name from Standard & Poor's—a rating agency now commonly referred to as the S&P. The S&P 500 comprises 500 of the largest publicly traded companies by market capitalization. It is also known as a market capitalization-weighted index or more commonly known as market cap-weighted. That means the larger a company's market cap, or the total value of a company’s stock, the more influence it has on the overall index's performance.
Since the S&P 500 comprises 500 companies, think of it as a pie sliced into 500 pieces. Each “slice” would be equally sized if all the companies had the same market cap. However, since market caps vary among each company, each size of the slice will vary and affect the overall index differently.
Many of the companies listed on the S&P 500 are also called blue chip stocks, and the index is accepted as a barometer of overall market health. Investors can view the quote S&P 500 index on the tastytrade platform by entering SPX into the symbol field of any trading platform. Other S&P 500 products include the popular ETF SPY, an alternate index XSP (1/10th the size of SPX), and /ES futures contracts.
It is worth noting that investors cannot "buy" the S&P 500 index SPX, since it is a composite index, but there is an SPX options market. SPX options are only traded on the CBOE (Chicago Board Options Exchange) and options are subject to proprietary options fees on a per-contract basis, in addition to standard commissions and fees. SPY is the S&P 500 ETF that does offer shares of stock, as well as an options market.
2. Nasdaq Composite and Nasdaq 100 – NDX
- The Nasdaq is typically regarded as the technology sector benchmark
- NDX & QQQ are popular products that track the Nasdaq
- NDX is a cash-settled index with no shares of stock, whereas QQQ is an ETF where shares can be traded
When investors mention the Nasdaq, they are typically referring to technology and growth stocks. Unlike other stock indices that base their index on market cap, the Nasdaq Composite Index is heavily composed of growth-oriented stocks that usually exhibit technological advancement in some manner, making it a popular index that is heavily exposed to the technology sector. As a result, the Nasdaq can be more volatile than other indices.
The Nasdaq Composite and the Nasdaq 100 comprise stocks that trade on the Nasdaq stock exchange. The main difference is the number of stocks in each index and the sectors they represent.
The Nasdaq Composite includes all the companies that trade on the Nasdaq exchange across various sectors and industries. Like the S&P 500, the Nasdaq Composite is market cap-weighted, which means the more valuable a company’s total shares are, the more impact it has on the overall index. The Nasdaq Composite Index can be quoted on all tastytrade platforms by entering $COMP as the symbol.
The Nasdaq 100 is a subset of the Nasdaq Composite. The Nasdaq 100 includes 100 of the largest non-financial companies that trade on the Nasdaq stock exchange and primarily list companies in the technology, biotechnology, pharmaceutical, healthcare, and consumer goods industries. Companies listed in the Nasdaq 100 are responsible for most of the Nasdaq Composite's movement and are often seen as the most innovative companies in their sector. The Nasdaq 100 is also market cap-weighted. However, the index caps the percentage of a single company to prevent a single company's stock from influencing the overall index. The Nasdaq 100 can be quoted on all tastytrade platforms using the symbol NDX.
Investors seeking exposure to the most prominent growth stocks by market cap may evaluate stocks within the Nasdaq Composite or Nasdaq 100. It is worth noting that, like any other stock index, there is no way to "buy" the Nasdaq index NDX, but there is an options market. QQQ is the Nasdaq ETF that does offer shares to buy or sell, as well as an options market.
3. Dow Jones Industrial Average (DJIA) – DJX
- The Dow is typically regarded as the blue chip benchmark
- DIA is a popular product that tracks the Dow
- DIA is an ETF where shares and options can be traded or invested in
The Dow Jones Industrial Average (DJIA), or the Dow for short, is a stock index comprising 30 publicly traded large-cap companies that trade on the New York Stock Exchange (NYSE) and Nasdaq. The Dow gets its name from Dow Jones, a news publishing company that used to publish the average. Industrial refers to the index comprising industrial stocks, but other market sectors are also included. Like the S&P 500, the index may also be used as a barometer for the overall health and performance of the U.S. economy.
Although the Dow is widely quoted by investors and non-investors alike when referring to the overall health of the U.S. economy, it is important to note that it represents a smaller set of companies than the S&P 500 or Nasdaq. The Dow can be quoted on all tastytrade platforms using $DWCF as the symbol.
Aside from being comprised of a small number of stocks, another aspect of the Dow that makes it unique is how the index calculates its average. Instead of being market cap-weighted like other indices, the Dow is price-weighted, which means that higher-priced stocks affect the index's performance more than lower-priced stocks. Furthermore, the sum of all the 30 stocks within the Dow is divided by a specified divisor that considers stock splits, spin-offs, and other corporate actions that could affect the index. As a result of the Dow's price-weighting method, it is the largest nominal U.S. stock index that is widely quoted and has the most pronounced movement because of its small sample set and weighting method.
Investors seeking exposure to blue chip stocks can evaluate the stocks that comprise the Dow Jones Industrial Average. Like any other stock index, there is no way to “buy” the index since it is not a stock, and DJIA does not have an options market. However, DIA is the Dow Jones ETF that does have a stock and options market.
4. Russell 2000 – RUT
- The Russell is typically regarded as the small-cap stock benchmark
- RUT & IWM are popular products that track the Russell
- RUT is a cash-settled index with no shares of stock, where IWM is an ETF where shares can be traded
The Russell 2000, or the "Russell," maintains its name from the Russell Investments company that created the index. The index is a widely used benchmark for small-cap stocks and a subset of the Russell 3000, representing 3,000 of the largest publicly traded companies incorporated in the United States, spanning many market sectors. The Russell 2000 includes small-cap stocks valued between $250 million to $2 billion. In short, investors referring to the Russell 2000 are referencing small-cap companies.
The Russell 2000 can measure economic health like any other stock index, but it can be a barometer that measures investor sentiment referred to as "risk-on" or "risk-off." Small-cap stocks are younger companies with greater growth potential than their large-cap counterparts. That said, small-cap stocks are usually riskier and tend to experience more volatility, and thus may be considered more speculative than large-cap stocks.
During economic downturns, small-cap stocks can experience a more significant price drop since they may be less diversified or established than their large-cap counterparts. In other words, investors are less willing to invest and hold small-cap stocks during economic uncertainty, which can adversely affect small-cap stock prices. When investors are less inclined to hold small-cap stocks, which can be seen as a more speculative asset, they may adopt a "risk-off" mentality and sell small-cap stocks, which can drag the index down.
Conversely, when investor sentiment improves, investors may consider accumulating more small-cap stocks due to their growth potential when economic conditions improve. When investors decide to invest in small-cap stocks, it can drive the Russell 2000 up, indicating that investors are moving towards more speculative stocks and adopting a "risk-on" mentality by buying small-cap stocks that are part of the Russell 2000.
The Russell 2000 is a market-cap-weighted index, which means that the companies with the largest market capitalizations have a greater impact on the index's performance. The index is reconstituted annually to ensure that it accurately reflects the small-cap segment of the U.S. stock market. The Russell 2000 is often used as a benchmark for actively managed small-cap mutual funds and exchange-traded funds (ETFs). Investors can use the index to gauge the performance of their small-cap investments and compare them to the broader small-cap market. Investors can view the Russell 2000 on tastytrade by entering RUT into their symbol field on any of the trading platforms.
Investors seeking exposure to small-cap companies can evaluate stocks within the Russell. Like any other index, investors cannot “buy” the Russell 2000 since it is a composite index, but the RUT does have an options market. RUT is only traded on a single exchange (CBOE) and is subject to proprietary options fees on a per-contract basis, in addition to standard commissions and fees.
IWM is the Russell ETF that does have a stock and options market available.
Investors should obtain a copy of the investment company’s prospectus, which contains important information about the investment company, related risks, and expenses. Carefully read the prospectus before investing in an ETF.
All investments involve risk of loss. Please carefully consider the risks associated with your investments and if such trading is suitable for you before deciding to trade certain products or strategies. You are solely responsible for making your investment and trading decisions and for evaluating the risks associated with your investments.