Stock Market Index: The Basics
In Stock exchange : What is it, Who owns, controls it we had discussed about what is stock, what is stock exchange, the stock exchanges in the world, who owns and controls the stock exchange, how stock exchanges have evolved from trading floor to online trading. This post is about the index. What is index? How is it calculated?
What is stock exchange?
A stock exchange is an institution, organization, or association which hosts a market where stocks, bonds, options and futures, and commodities are traded. It can be thought of as a big room where stocks are sold and bought. If a particular company is traded on an exchange, it is referred to as “listed”. Just as there are many supermarkets in an area or many Khans in the Bollywood, a country can have more than one stock exchange. Two famous stock exchanges of India are Bombay Stock Exchange(BSE), National Stock Exchange(NSE).
As per BSE website total number of stocks/scrips listed on BSE are 8452. In NSE the number of companies listed are 1461 (Ref:CSV file at NSE)
http://www.bseindia.com/about/list_comp.asp
As per BSE website total number of stocks/scrips listed on BSE are 8452. In NSE the number of companies listed are 1461 (Ref:CSV file at NSE)
http://www.bseindia.com/about/list_comp.asp
What is index?
It would be too difficult to track every single security trading in a stock exchange. So a smaller sample of the market that is representative of the whole is taken. Just as the average marks in a class test tells you how the class has fared in the test,just as pollsters use political surveys to gauge the sentiment of the populationthe stock index tells you the general health of stock market. If the stock market is doing well, then the prices of stocks tend to rise in what is known as a bull market. If it’s doing poorly, prices as a group tend to fall in what is called a bear market.
In India Sensex is an index that captures the increase or decrease in prices of stocks of 30 companies that are traded on the BSE. The word Sensex comes from sensitive index and was coined by Deepak Mohoni.
Nifty is the Sensex’s counterpart on the NSE and comprises of 50 companies.
How is index calculated?
An index can be calculated in various ways. Some of them are as follows:- Price Weighted index: Ex: Dow Jones Industrial Average,Nikkei 225
- Market value weighted or capitalization-weighted: NASDAQ Composite, NASDAQ-100,
- Free Float Market Capitalisation Weighted: Sensex, Nifty-50, FTSE-100, CAC 40
Price Weighted Index:A stock index in which each stock influences the index in proportion to its price per share.Stocks with a higher price will be given more weight and, therefore, will have a greater influence over the performance of the index.
For example, assume that an index contains only two stocks, one priced at 1 and one priced at 10. The 10 stock is weighted nine times higher than the 1 stock. Overall, this means that this index is composed of 90% of the 10 stocks and 10% of 1 stock. In this case, a change in the value of the 1 stock will not affect the index’s value by a large amount, because it makes up such a small percentage of the index. The Dow Jones Industrial Average is an example of a price-weighted stock market index.
Market-value weighted or capitalization-weighted: Such index ex:Hang Seng Index factors in the size of the company. It’s individual components are weighted according to their market capitalization, so that larger components carry a larger percentage weighting. Some investors feel that this over-weighting toward the larger companies gives a distorted view of the market, but the fact that the largest companies also have the largest shareholder bases makes the case for having the higher relevancy in the index.
Free Float Market Capitalization Weighted:is calculated by taking the stock price and multiplying it by the number of shares readily available in the market. Instead of using all of the shares outstanding like the full-market capitalization method, the free-float method excludes locked-in shares such as those held by promoters and governments.
Yet another variation are Fundamental indexes, which use factors such as dividends, cash flow, sales and book value rather than market cap to determine relative weight
Nifty-50 and Sensex Calculation
From June 26, 2009, S&P CNX Nifty is computed using Free Float Market Capitalisation weighted method.The base period selected for S&P CNX Nifty index is the close of prices on November 3, 1995. The base value of the index has been set at 1000 and a base capital of Rs.2.06 trillion. For details check Index computation at NSE Website
SENSEX, first compiled in 1986, was calculated on a Market Capitalization-Weighted methodology of 30 component stocks representing large, well-established and financially sound companies across key sectors. The base year of SENSEX was taken as 1978-79.Since September 1, 2003, SENSEX is being calculated on a free-float market capitalization methodology. For details on how to calculate Sensex One can read with detailed explanation at Onemint How Sensex is Calculated
Why do we need Index?
Every stock price moves for two possible reasons: news about the company (e.g. a product launch, or the closure of a factory, etc.) or news about the country (e.g. nuclear bombs, or a budget announcement, etc.). The job of an index is to purely capture the second part, the movements of the stock market as a whole.The news that is common to all stocks is news about the country . On any one day, there would be good stock-specific news for a few companies and bad stock-specific news for others. In a good index, these will cancel out, and the only thing left will be news that is common to all stocks.. That is what the index will capture.Index is calculated using different methods which do some kind of averaging so that, the individual stock news/fluctuations cancel out reducing risk. The averaging that takes place in an index is equivalent to diversification. Index are like a thermometer for the stock market – they give us a general sense of whether things are hot or cold.
Stock market indexes are useful for a variety of reasons. Some of them are :
- They provide a historical comparison of returns on money invested in the stock market against other forms of investments such as gold or debt.
- They can be used as a standard against which to compare the performance of an equity fund.
- In It is a lead indicator of the performance of the overall economy or a sector of the economy
- Stock indexes reflect highly up to date information
- Modern financial applications such as Index Funds, Index Futures, Index Options play an important role in financial investments and risk management.
Comparison of Indices of the World
Interesting Read:Good Bad and Ugly of Index
Why don’t we put all the stocks of the exchange into the index?
There is little to gain by diversifying, beyond a point. Putting more stocks into an index yields more diversification but there are diminishing returns to diversification. Going from 10 stocks to 20 stocks gives a sharp reduction in risk. Going from 50 stocks to 100 stocks gives very little reduction in risk. Going beyond 100 stocks gives almost zero reduction in risk. Secondly If the stock is illiquid, the observed prices yield would contain contaminated information and actually worsen an index. Hence Sense has 30 stocks and Nifty 50 stocks.How many indices can a Stock exchange have?
It’s not unusual for people to talk about “the market” as if there were a common meaning for the word. The most important type of market index is the broad-market index, consisting of the large, liquid stocks of the country. In most countries, a single major index dominates benchmarking, index funds, index derivatives and research applications. In India we have two major Stock index, Sensex of BSE and Nifty-50 of NSE. But many indexes of the differing segments of the market exists. These different indices don’t always move in tandem. If they did, there would be no reason to have multiple indexes.
BSE has following indices:
- Broad based Indices like SENSEX, BSE-100, BSE-200, BSE-500, BSE Mid-Cap and BSE Small-Cap index
- Sector Indices like:BSE Auto Index, BSE BANKEX, BSE Capital Goods Index, BSE Consumer, Durables Index, BSE FMCG Index, BSE Healthcare Index, BSE IT Index, BSE Metal Index, BSE Oil & Gas Index, BSE Power Index, BSE Realty Index
- Major indices like: S&P CNX Nifty, CNX Nifty Junior, CNX 100,Nifty Midcap 50
- Sectoral Indices like CNX Auto,CNX Bank, CNX Energy
- Thematic indices like: CNX Commodities, CNX Consumption, CNX PSE
Index is not static-it’s dynamic
It’s not that once index is made it is frozen. Its composition changes. The world changes, so the index should change.For example:On Aug 8 2011 Coal India, Sun Pharma replaced ADAG stocks in top 30. Coal India Limited replace Reliance Capital stock in Nifty 50 from 10 Oct. Bosch Ltd, Dabur India, Idea Cellular and Reliance Capital made their entry into CNX Nifty Junior Index from 10 October.ACoal India Ltd, Patni Computer Systems, Punj Lloyd and Syndicate Bank moved out ofCNX Nifty Junior Index . Ref:Firstpost
The change is not sudden – for that would disrupt the character of the index. Exchange use clear, researched and publicly documented rules for index revision. These rules are applied regularly, to obtain changes to the index set. Index reviews are carried out ensure that each security in the index fulfills all the laid down criteria. IDBI was once not listed; SBI was once illiquid; Infosys was once an obscure software startup. A stock may be replaced from an index for the following reasons:- Compulsory changes like corporate actions, delisting etc. In such a scenario, the stock having largest market capitalization and satisfying other requirements related to liquidity, turnover and free float will be considered for inclusion.
- When a better candidate is available in the replacement pool, which can replace the index stock i.e. the stock with the highest market capitalization in the replacement pool has at least twice the market capitalization of the index stock with the lowest market capitalization.
Who Regulates the Stock Market
Every country has it’s own regulatory body. In the United States, it is the Securities and Exchange Commission, commonly known as the SEC.In India Stock market is regulated by following governing bodies:
- Securities and Exchange Board of India (SEBI)
- Department of Economic Affairs (DEA)
- Department of Company Affairs (DCA)
- Reserve Bank of India
- Stock exchanges
Governance
Nifty is managed by a professional team at IISL, a company setup by NSE and CRISIL with technical assistance from Standard & Poor’s. There is a three-tier governance structure comprising the board of directors of IISL, the Index Policy Committee, and the Index Maintenance Subcommittee. S&P CNX Nifty has fully articulated and professionally implemented rules governing index revision, corporate actions, etc. Ref:NSE website
Psychology of the Stock Market Cycle
Very well written article giving knowledge about the stock market helpful for beginners. Author also giving good nifty option trading tips with sure calls.
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