Throwing all your financial eggs into a small basket of individual securities can be wildly profitable when you are right, but devastating if you are wrong. Diversification is key, especially in the highly volatile markets of 2008. I’ve lost count of how many times this year the market indexes have gained and lost two percent and then re-gained again and re-lost that same two percent – all in a single week.

Trading the indexes is one way to get instant diversification. You may lose out on a potential jackpot return from an individual stock, but you are also not likely to lose everything either. But in order to trade the indexes effectively, it helps to know the indexes you are trading, and also have a plan in place to match your trading style. The number of ETF indexes available for trading today is incredible when you you count all the main indexes, foreign indexes, sector indexes and inverse indexes and inverse sector indexes. But probably the three most commonly traded indexes are the following:

Dow Jones Industrial Average – The most widely known index. It was started on May 26, 1896 by financial reporter Charles Dow to provide a quick financial gauge of the nations largest firms. It is composed of only 30 companies but is considered highly diverse. The actual components can and do change over time. Only General Electric has managed to survive its membership in the index since 1896. Trading the Dow Jones is easily accomplished through the Dow Diamonds ETF (symbol DIA). The performance can also be easily tracked by monitoring the DIA ETF directly, or by catching highlights of the actual Dow Jones that is broadcast on virtually every medium that discusses the market. One oddity of the Dow Jones index is that it is price weighted, and not market cap weighted. Comapnies with the higher stock price (not higher market cap) have a larger weight in the index. The latest DIA sector weightings, from Yahoo Finance are shown below. The top two sectors are currently industrial materials and energy, but these weighting can and do change.

S&P 500 – The S&P 500 index is comprised of 500 leading companies across over 100 unique sectors. Unlike the Dow Jones, the S&P 500 index is weighted by market cap. The largest firms by market cap value have the biggest impact on the S&P market reading. The top two sectors from Yahoo Finance are currently energy and financial services. It is interesting to note that the percentage weight in financial services has dropped significantly over the last year due to the severe losses incurred from financial institutions. One of the easiest ways to trade the S&P 500 is through the State Street S&P 500 Spider ETF (symbol SPY).

Russell 2000 -While the Dow Jones and S&P are concentrated in big cap names, the Russell 2000 measures the performance of the small cap segment of the market. But it leaves out the tiny mini and micro-cap securities. The Russell 2000 is derived from the Russell 3000 index. The Russell 3000 measure the performance of the largest 3000 U.S. companies. The smallest 2000 of those 3000 companies is the index of the Russell 2000. It can be traded easily with the iShares Russell 2000 index fund (symbol IWM). The top two sectors, per Yahoo Finance, are financial services and industrial materials. But the financial services components in the Russell 2000 index are the small cap financial services components, and not the same as the S&P 500 financial services components.

Trading a plan for the indexes – When trading any of the three indexes above, you should keep in mind the top sectors within your preferred index, as well as the support, resistance and trading channels of your preferred index.

For a more detailed view of trading the indexes, I recommend:
The Index Trading Course (Wiley Trading)
The Index Trading Course (Wiley Trading) by George A. Fontanills