The Practical Guide to Wall Street: Equities and Derivatives

CHAPTER 4

Equity Indices

INTRODUCTION

“How’d the market do today?” is quite possibly the most commonly asked finance question in the world. For those who work in the financial markets and are expected to have a ready answer to this question at all times, it can be a frustrating one given its ambiguity. An emerging market bonds trader will have a very different definition of “the market” than a floor broker on the New York Mercantile Exchange in the crude oil futures pit. What is more, it is unlikely that the person asking is interested in what either of these people have to say about their markets because “How did the market do today?” is usually intended as a shorthand way of asking “Give me a five-second summary of how the U.S. equity market performed today.” Equity indices give us the best way of answering this question.

An equity index is a weighted average of a selected group of stocks’ prices, which is designed to summarize the performance of all or part of the equity market. Equity indices are useful because they synthesize the massive amounts of stock price data in the marketplace into more readily understandable aggregates. Most of us are familiar with several, particularly the Dow Jones Industrial Average (DJIA), which, despite its flaws, has a special place in the hearts of U.S. retail investors due to its longevity, having been calculated continuously, in various forms, since 1896.

Strangely, many people have difficulty understanding what an index really is and ...