Indices and ETFs: what the yardstick is made of

After this lesson you'll know what the S&P 500 actually is, what an ETF does, and what cap-weighting hides.

An index is a list with arithmetic

The S&P 500 is a list of roughly five hundred large US companies and a rule for combining their prices into one number. The rule is cap-weighting: each company counts in proportion to its market capitalization (course 4). Apple, worth trillions, moves the index hundreds of times more than the smallest member does.

The consequence is easy to miss, so here is a number for it: in recent years the ten biggest companies have made up over a third of the S&P 500's entire weight, while the smallest hundred together barely register. So "the market was up today" is mostly a report about a handful of giants. The Nasdaq-100 is more concentrated still. When you hear that an index did something, the useful next question is which few names actually did it. School IV's market-regime course takes that up under the name breadth.

From a number to something you can own

An index is a calculation, so there is nothing there to own. The wrapper that fixes that is the ETF, an exchange-traded fund, which holds the index's basket of stocks and itself trades on the exchange like any share. SPY holds the S&P 500's stocks and QQQ holds the Nasdaq-100's. Behind the scenes, professional arbitrageurs create and redeem ETF shares whenever the fund's price drifts from the value of its basket, and their profit-taking is what keeps the two stuck together. The details are beyond this course. For the giant ETFs, what you need to know is that the link holds tightly.

The scale of all this changed markets themselves. Passive index money is now enormous and it trades mechanically, mostly at the close, which is how course 6's closing auction grew into the biggest liquidity event of the day.

Why the index keeps turning up

The index is the yardstick. From School IV onward, calling a stock "strong" means it went up more than something else did, and that something else is usually the index. The index's own condition, its trend and how many of its members are participating, is the weather report that decides how aggressively a trader should be positioned at all. Both of those get whole courses later.

Check yourself

1. The S&P 500 rises 1% on a day when 300 of its 500 stocks fell. How? (Cap-weighting. Gains in the biggest names outweigh declines in hundreds of small ones.)
2. What keeps SPY's price near the value of the stocks it holds? (Arbitrage through creation and redemption — professionals profit from any gap until it closes.)
3. Why will "the index" show up in nearly every later course? (It's the benchmark strength is measured against, and its own health sets the regime.)

The idea this lesson installs

"The market" is mostly its ten biggest names; know what your yardstick measures.

Next: Course 8 — "What moves markets."