A stock market index (or just stock index) measures the value of a specific section of the stock market. A stock index takes a number of different companies’ stocks and groups them together so they can be traded as one financial instrument. An index therefore captures the performance of these stocks as ONE number.
Stock indices are calculated from the prices of these selected stocks and are usually weighted. They are a tool used by investors and traders to describe the stock market, and for comparison purposes between different sectors of the market. When investors are referring to the performance of ‘the market’ they are referring to the performance of a stock index.
Trading Stock Indices
A stock index itself is just a mathematical construction to measure the performance of the stock markets. It cannot be invested in directly meaning investors cannot own a stock index directly like they can shares.
Instead, investing in stock indices is made accessible through exchange-traded funds (ETFs) which track the performance of the index or through derivatives such as option and futures contracts.
Futures contracts of stock indices are the instruments we trade with our broker. These instruments are based on the underlying price of the index and will move in line with them.
The first ever ETF to track an index was the S&P500 (SPDR). This was developed to track the performance of the 500 largest companies in the US. Now, there are literally hundreds of ETFs and futures contracts which track different groups of stock.
Types of Stock Market Indices
Stock market indices may be categorized in many ways. A ‘world’ or ‘global’ stock index is made up of companies irrespective of where they are based or traded.
A ‘national’ index’ represents the performance of the stock market in a given nation and therefore reflects investor sentiment on the state of its economy. The most regularly traded national indices are made up of the stocks of the largest companies listed on the nations stock exchanges. Examples include the US S&P 500, the Japanese Nikkei 225, and the UK’s FTSE 100.
Stock indices can also represent the performance of companies of more extensive geographical regions.
The DJ Euro Stoxx 50 consists of the stock of 50 blue-chip companies based in the Euro Zone only. The MSCI Emerging Markets Index is made up of stock from emerging economies only such as Brazil, Mexico and South Africa.
Finally there are unique indices that relate to certain industry sectors. The NASDAQ 100 for example primarily consists of companies in the technology industry and totally omits financial companies. The point is that there are hundreds of different types of indices which measure the performance of stock in different sectors and areas.
However, most traders focus on the main national indices we mentioned above.
Types of Weighting
Each stock in an index is usually given a level of weight, or importance. When there is no weighting method used it is called an ‘Equal-Weighted Index’ as all companies carry the same level of importance whether they are a large company or small.
This type of method is unusual however and the most popular indices have some form of weighting applied. Below we will briefly discuss the two most common types of weighting methods used.
A price weighted index is where each stock is weighted according to its price only i.e. the price of the stock is all that is considered when weighting that company in the index.
Therefore a stock trading at $100 per share (company A) is 5 times more of the total index than a stock trading at $20 per share (company B). This means that a price move in company A’s shares is likely to have a much bigger impact on the index than a price move in company B’s shares. Examples of price-weighted indices include the Dow Jones 30 and the Nikkei 225.
One of the shortfalls of the price-weighted method is that it doesn’t consider the overall size and market value of the company. The capitalization-weighted method will weigh companies based upon the total market value of all their shares i.e. share price times the amount of outstanding shares.
In our example above we said that company A will have a greater weight on the index because its share price is 5 times greater than company B’s under the price-weighted model. However, a company’s true value is not reflected solely in its share price, and company A might be a smaller company than company B.
For example, if company A has only 100,000 outstanding shares then its market capitalization (market cap) is $10m. But if company B has 1m outstanding shares then it has a market cap of $20m.
So under a capitalization-weighted index, company B is given twice the weight of company A.
A capitalization-weighted index can also be called a market-value weighted index. Capitalization-weighted indices are the most popular type of index and examples include the S&P 500, FTSE 100, CAC 40 and DAX 30.
What Moves the Price of a Stock Index?
As stock indices can be a group of any type of stock the factors that move the price will vary. Large national stock indices such as the S&P500 in the US will be heavily influenced by macroeconomic factors in the US economy as well as the microeconomic factors of the companies which make it up.
Therefore, as a trader, we need to keep an eye on the performance and profitability of the main companies in the index but also the economic climate of the index’s base nation. Some key economic indicators that shape the price of a stock index include but are certainly not limited to:
- Interest rates
- Employment levels
- Price of energy and precious metals
- Exchange rates
- Political policies & decisions
- Monetary and Fiscal policy
Some stock indices and ETFs track the performance of stock in a specific sector of the economy such as technology, financial services, real estate or healthcare. If we are trading this type of instrument we need to be aware of the current economic state and profitability of that sector.
In our next six articles we will take a closer look at some of the most popularly traded stock indices; what they consist of and how they are calculated including the Dow Jones Industrial Average 30 (US), Standard & Poor’s 500 (US), FTSE 100 (UK), DAX 30 (Germany), CAC 40 (France) and Nikkei 225 (Japan).