An index is a collection of stocks that tracks the overall performance of a specific sector, or the market as a whole. An index isn't a security. It doesn't have a board of directors, it doesn't have its own balance sheet, and it has no shares to sell. When you hear that the TSX is up 1% today, that's the index's formula weighing the prices of its component stocks.
An index acts more like a thermometer for how the market is doing, rather than something you can own outright. Investors who want exposure to an index can buy an index ETF or trade index options instead, both of which incorporate stocks you actually can buy and sell.
Even investors who don't invest in an index will often compare their own portfolio's performance against it, to see whether they're doing better or worse than the market. Indexes also come up constantly when the news is trying to gauge the impact of a major world event.
Popular indices
One of the first indices, and still one of the most widely known, is the Dow Jones Industrial Average, more commonly called the "Dow." It was originally launched in 1896 to track 12 industrial companies, but today it tracks 30 companies chosen to represent the United States economy. Those 30 stocks are picked by a selection committee and updated as needed. The Dow uses price weighting, meaning every dollar movement in one of its 30 stocks moves the index by a dollar.
Meanwhile, the most popular index today is the S&P 500, which tracks the 500 largest American companies. A company's size here is measured by market capitalization, which is just its share price multiplied by the total number of shares it has out there. The S&P 500 gets watched more closely than the Dow because it's so much broader – however, its price uses market cap weighting instead of the Dow's price weighting, meaning companies with a bigger market cap move the index more than smaller ones do.
Canadian index
The most popular Canadian index is the S&P/TSX Composite Index, which tracks roughly 220 of the largest Canadian companies by market capitalization. Those 220 companies' combined market cap makes up roughly 70% of the entire market cap of the Toronto Stock Exchange, which is why the index is considered a good representation of the Canadian stock market.
If you're interested in a narrower slice, the S&P/TSX 60 narrows things down to the 60 largest companies in Canada.
Investing in an index
While you can't buy shares of an index directly, there are ways to get exposure to one. The most popular method is investing in an ETF that tracks the index. Plenty of companies offer index ETFs, and they compete with each other on management fees. These ETFs aim to copy the performance of the index, holding the same stocks at the same weighting. If you want to diversify without a lot of hands-on management, index ETFs are worth looking into, since they tend to be broadly diversified and carry low fees.
For options traders, index options are a way to bet on which direction an index will move by a given expiry date. Since you can't buy shares of an index itself, index options are cash-settled: the difference between the strike price and the index price at expiry gets paid out between buyer and seller. And unlike traditional equity options, index options can only be exercised on the expiry date, not any time before.
Summary
An index is a benchmark for how the market is performing. It's the number the news uses for when something big happens so they can quickly gauge the impact on the market. Investors also use it to check whether their own portfolio is beating the market or falling behind. You can't invest in an index directly, but index ETFs and index options both give you a way in.
