Since indices like the DAX and Dow Jones are headlines in the financial world on a daily basis, what is an index and how can traders benefit from adding them to their trading? Let's start with the basics. The index, also known as the stock market index, is a measure of the aggregate of companies and is used to measure the performance of a sector, region, or economy of a country.
The first index was created by the Wall Street Journal editor and Dow Jones & Company co-founder Charles Doe in 1885. Before the digital era, the price of an index was calculated using simple averages, that is, the sum of the prices of the components. companies and dividing it by the number of companies. This may seem like an oversimplification these days, but it really served the purpose of providing a reliable figure to measure the strength of the US economy.
Indices today use different formulas to determine their price, which can be divided into two main categories, which is a key point for traders to understand before evaluating the performance of an index.
1. Market Value Weighted Indices
Market indices are calculated based on the total market value of its member companies. This means that the larger the company, the more influence it has on the index. This is the most common methodology used by indexes, with the FTSE and DAX being classic examples.
2. Price Weighted Indices
This type of index is calculated based on the stock price of its companies. In this case, the companies with the higher share price have a greater influence on the overall index than the companies with the lower price.