US Index Trading: Everything You Need To Know
Axi | Mar 19, 2019 13:13
Index trading can be a useful tool for traders looking to take a view on the fortunes of a specific country, sector or genre of asset. There’s no shortage of different indices produced, but the ones we’re most familiar with are arguably those for blue chip equities. The FTSE 100 in London, the DAX 30 in Frankfurt, the Nikkei 225 in Tokyo, and so the list goes on. Two indices which are often of specific interest however are the Dow Jones Industrial Average and S&P 500, both of which cover many of the biggest stocks on Wall Street.h2 The S&P vs the DOW/h2
The S&P is made up of 500 of the largest publicly traded companies in the US and is weighted by market capitalisation. The more the company is worth (shares in issue multiplied by the share price itself), the greater its weighing in the index. Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL) and Amazon (NASDAQ:AMZN) are currently the biggest three stocks in the S&P 500, collectively accounting for just over 10% of the index. Companies like Gap (NYSE:GPS) are currently amongst the smallest constituents – to date, Gap currently ranks 489th and represents just 0.024% of the index.
The Dow is however subtly different. It looks at the performance of just 30 of the largest (note not the 30 largest) US publicly traded stocks and is calculated on the basis of something called a price-weighted index. That means, the companies with the higher share price – not market capitalisation - are the ones that carry the most weight, with factors such as historic stock splits and dividend payments also being taken into account. The peculiarity has certainly produced some abnormal price performance for the index in the last week.
Because of the unusual structure, Boeing (NYSE:BA) is currently the largest constituent in the Dow, representing almost 10% of the index and having a market capitalisation of $210 billion. Pfizer (NYSE:PFE) is currently the smallest constituent in the Dow, representing just 1% of the index yet having a market capitalisation of $225 billion. The 10% collapse in Boeing’s share price on March 11th, following a second tragic accident involving a new version of the 737 was therefore sufficient to have a meaningful impact on the index as a whole.
h2 So what does this tell us about trading the S&P versus the DOW?/h2- The S&P has a more traditional weighting method, so it’s unlikely to be exposed to significant shocks.
- The S&P does however have a big weighting across the three tech giants – Apple, Microsoft and Amazon. If all three of these sell off in unison, it could make quite an impression on the index.
- The Dow lacks diversification. Being made up of only 30 stocks and with four of them accounting for almost 30% of the index, the Dow will be subject to higher levels of short-term volatility than the S&P.
- But over the longer term, volatility on the Dow and the S&P is very closely correlated.
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The CBOE – Chicago Board of Exchange – helpfully calculates a number of volatility indices, including the VIX (for the S&P 500) and the VXD (for the Dow Jones Industrial Average). The numbers are based on real-time prices of options on the respective underlying index and are designed to reflect a consensus view of the expected stock market volatility in the next 30 days. Sometimes these metrics are referred to as 'fear gauges' – the higher the index, the greater the expectation of volatility in the coming month.
The chart above shows the correlation between the volatility gauge for the S&P 500 and the Dow 30 at the start of each week, going back to the start of the decade. Week-1 is the week starting March 10th, 2019. As can be seen, there is little deviation between the two metrics.
However, looking at the average range posted by each index shows a very different story. In an average week over the last nine years, the VIX showed a range (calculated by the weekly high minus the weekly low, divided by the weekly low) of 24%. Compare that to the VSD covering the less diversified DOW and the average range of the index comes in at a shade over 36%.
h2 The takeaway/h2With this in mind, the numbers show that short term intra-day traders may potentially favour the Dow, given its higher levels of short term volatility. Conversely, those looking to trade a longer-term trend may possibly want to consider the S&P.
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