A stock market index (indices: plural) is a statistical measure of the relative value of a group of stocks. Often used as a benchmark for market performance, as the stock prices in this group change value, the relative value of the index also changes in value. Described in terms of a number of points, stock market indices are either price weighted or capitalization-weighted. That is, either calculated according to price or market capitalization. Classified as with broad or narrow based, a broad-base index is designed to represent the performance of the entire stock market while a narrow-based index follows the performance of stocks that have a specific characteristic, such as belonging to a particular industry (ie: technology industry).show more
While most developed economies are represented by at least one financial index, the Dow Jones Industrial Average (DJIA) is the oldest and probably the most widely followed and recognised stock market index in the world. In Australia, the S&P/ASX 200 index is the representative stock market index.
Traded on a margin using leverage and offering traders the opportunity to participate in the market without the need to buy or sell multiple assets (or instruments), an index market trader can go ‘long’ on a particular index if they believe that stocks in that market are likely rise, or go ‘short’ on an index if they predict that the stocks in that market are likely to fall.
Because a stock market index is a benchmark measure of the performance of a group of stocks, a weighted index (price or market capitalization) puts more importance (or weighting) to each stock that meets a specific criteria therefore representing a greater (or lesser) part of the index. Changes in the index price therefore represent changes in the price or market capitalization of the companies in the index.
When there is no weighting method used, the index is known as an ‘Equal Weighted Index’. That is, all stocks carry the same level of emphasis (or weighting) irrespective of their size or criteria.
Price Weighted Index
A price weighted index (also known as an equal dollar weighted index) is a stock market index which each stock is weighted proportionally according to its price. That is, stocks with a higher price per share will have a greater (or disproportionate) weight in the index.
The total value of a price weighted index is calculated by adding the prices of each of the stocks in the index and dividing them by the total number of stocks. The Nikkei 225 (N225) and the Dow Jones Industrial Average (DJIA) are both price-weighted indices.
EXAMPLE: If Company A, Company B and Company C have a share price of $51.16, $36.97 and $13.63 respectively. Using these share prices, the calculated price-weighted average value is $33.92 ($51.15 + $36.97 + $13.63 / 3).
If Company A releases favourable news and its share price rises by 20% to $61.39 this would raise the price weighted average index value to $37.33, a 10.05% increase.
Conversely, if the price of Company C rather climbed 20% in value to $16.36, the value of the price weighted average index would increase just 2.68% to $34.83.
That is, a 20% price movement in Company A has a 4-times greater impact on the value of the price weighted index than Company C.
Capitalization Weighted Index
A capitalization weighted index (also known as a market-value weighted index) is a stock market index which each stock is weighted according to the total market value of their outstanding shares. Calculated as the current stock price times outstanding shares divided by a divisor (a number that is defined when an index is first established), stocks with the largest market values have the heaviest weighting in the capitalization 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.
EXAMPLE: If Company A, Company B and Company C have a market capitalization of $25,000,000 (1,000,000 x $25), $16,500,000 (300,000 x $55) and $10,000,000 (500,000 x $20). Using these market cap values, the entire market value of the index components is $51.5 million giving Company A a weight of 48.5%, Company B a weight of 32.1% and Company C a weight of 19.4%.
If Company A releases favourable news and its share price rises to $35.00 this would raise the market value of the index components to $61.5 million and increase Company A’s weighting to 56.9%.
Stock index price movements are measured in ‘points’ as well as ‘ticks’.
A point (when referring to stocks and stock market indices) is equal to $1. It is the smallest possible price change (1) on the left side of the decimal point.
Also referred to as ‘tick size’, a tick is the minimum price change (or movement) for the particular index market. Different markets have different tick sizes.
EXAMPLE: If the S&P500 increases from 2,519.00 to 2,520.00 this is an upward price movement of one point. If one paid is made up of four ticks, the S&P500 moves in 0.25 tick movements.
Other than stock market indices, there are a number of index markets that are traded on global exchanges.
A commodity index is calculated to be representative of a broad commodity asset class such as energy (coal, crude oil, ethanol, natural gas, etc), metals (base or precious metals such as lead, copper, gold, silver, etc) or agriculture (grains, softs or livestock such as corn, soybeans, coffee, sugar, hogs, live cattle, etc). Traded on global exchanges, the value of a commodity index changes based on the underlying commodity prices.
Fixed Income Indices
A fixed income index measures the performance of the short-term money and bond market (also known as the debt or credit market). Mostly calculated using weighted capitalization from prices of selected bonds and classified based on credit rating or maturity date, bond indices are composed of government, corporate and high-yield bonds as well as mortgage backed securities and leveraged loans.
A volatility index is a market sentiment indicator that provides investors, traders, economists and financial researchers an understanding into current market sentiments and anticipated levels of market volatility. When investor sentiment reaches extreme levels, the market typically reverses.
The Dow Jones Industrial Average (commonly referred to as the Dow), is the world’s oldest stock index. First calculated in May 1896, the Dow measure the performance of 30 large publicly traded companies from a number of market sectors (from financial service to healthcare). Calculated using the price-weighted method, the Dow moves upward and downward in tick price increments of 1.00 and trades using the US Dollar as the base currency. The Dow is widely considered to be strong indicator of the US economy and investor sentiment towards equities.
A popular benchmark for the US stock market, the Standard and Poor’s 500 (abbreviated to S&P 500) is a stock market index made up of 500 leading, large, blue-chip companies publicly traded in the US stock market (the S&P 500 contains all of the stocks in the Dow Jones with an additional 470). Calculated using the capitalization-weighted method, the S&P 500 moves upward and downward in tick price increments of 0.25. The base currency of the S&P 500 is the US dollar.
First traded in January 1984, the Financial Times Stock Exchange 100 Index (abbreviated to FTSE 100 and referred to as the ‘footsie’) is a stock market index made up of 100 companies listed in the London Stock Exchange (LSE) with the highest market capitalization. Calculated using the capitalization-weighted method, the FTSE 100 moves upward and downward in tick price increments of 0.50. The base currency of the S&P 500 is the British Pound.
Considered a strong indicator of Europe’s economic performance and financial health, the CAC 40 is a benchmark French stock market index. Taking its name from the Paris Bourse’s early automation system the Cotation Assistée en Continu (Continuous Assisted Quotation), the CAC 40 measures the performance of the 40 largest, publicly traded companies on the Euronext Paris France’s stock market. Calculated using the capitalization-weighted method, the CAC 40 moves upward and downward in tick price increments of 0.50. The base currency of the CAC 40 is the Euro.
First traded on in December 1987, the DAX 30 Stock Market Index (Deutscher Aktien IndeX) is a blue chip stock market index of 30 large German companies. Traded on the Frankfurt Stock Exchange and calculated using the capitalization-weighted method, the DAX 30 is considered a strong indicator of the strength of the German economy and investor sentiment towards German equities. The DAX 30 moves upward and downward in tick price increments of 0.50 and trades using the Euro as its base currency.
First calculated in 1950, the Nikkei 225 (abbreviated to N225 or simply Nikkei) is the stock market index for the Tokyo Stock Exchange (TSE). Calculated daily by the Nihon Keizai Shimbun (Nikkei) newspaper using the price-weighted method, the N225 is heavily comprised of technology companies including pharmaceuticals, electric machinery and communications. Considered a strong indicator of the strength of the Japanese economy and investor sentiment towards Japanese equities, the N225 moves upward and downward in tick price increments of 1.00 and trades using the Japanese Yen as its base currency.
A popular benchmark for the Australian stock market, the ASX 200 is a stock market index measuring the performance of the largest 200 public companies listed on the Australian Securities Exchange. Launched in April 2000 and calculated using the weighted-capitalization method, the ASX 200 moves in tick price increments of 1.00 and trades using the Australian Dollar as its base currency.
*Specifications listed above for trading index markets are subject to change and must be referenced with participating brokers.