An ideal index gives us minute by minute reading about how the market

The Stock Markets Index

 

The Index Overview

 

It would be clumsy to check each and every company, figure out if they are up or down for the day and then give a detailed answer. Instead you would just check few important companies across key industrial sectors. If majority of these companies are moving up you would say markets are up, if the majority is down, you would say markets are down, and if there is a mixed trend, you would say markets are sideways!

 

So essentially identify a few companies to represent the broader markets. So every time someone asks you how the markets are doing, you would just check the general trend of these selected stocks and then give an answer. These companies that you have identified collectively make up the stock market index!

 

Luckily you need not actually track these selected companies individually to get a sense of how the markets are doing. The important companies are pre packaged, and continuously monitored to give you this information. This pre packaged market information tool is called the ‘Market Index’.

 

There are two main market indices in India. The S&P BSE Sensex representing the Bombay Stock Exchange and CNX Nifty representing the National Stock Exchange. S&P stands for Standard and Poor’s, a global credit rating agency. S&P has the technical expertise in constructing the index which they have licensed to the BSE. Hence the index also carries the S&P tag.

 

CNX Nifty consists of the largest and most frequently traded stocks within the National Stock Exchange. It is maintained by India Index Services & Products Limited (IISL) which is a joint venture of National Stock Exchange and CRISIL. In fact the term ‘CNX’ stands for CRISIL and NSE.

 

An ideal index gives us minute by minute reading about how the market participants perceive the future. The movements in the Index reflect the changing expectations of the market participants. When the index goes up, it is because the market participants think the future will be better. The index drops if the market participants perceive the future pessimistically.

 

 

Uses of the Index

 

Some of the practical uses of Index are discussed below:

 

Information – The index reflects the general market trend for a period of time. The index is a broad representation of the country’s state of economy. A stock market index that is up indicates people are optimistic about the future. Likewise when the stock market index is down it indicates that people are pessimistic about the future.

 

Benchmarking – For all the trading or investing activity that one does, a yardstick to measure the performance is required. Well suddenly it may seem to you, that you have underperformed the market! If not for the Index you can’t really figure out how you performed in the stock market. You need the index to benchmark the performance of a trader or investor. Usually the objective of market participants is to outperform the Index.

 

Trading - Trading on the index is probably one of most popular uses of the index. Majority of the traders in the market trade the index. They take a broader call on the economy or general state of affairs, and translate that into a trade.

 

Portfolio Hedging – Investors usually build a portfolio of securities. A typical portfolio contains 10 – 12 stocks which they would have bought from a long term perspective. While the stocks are held from a long term perspective they could foresee a prolonged adverse movement in the market (2008) which could potentially erode the capital in the portfolio. In such a situation, investors can use the index to hedge the portfolio. We will explore this topic in the risk management module.

 

 

Index Construction Methodology

 

It is important to know how the index is constructed /calculated especially if one wants to advance as an index trader. As we discussed, the Index is a composition of many stocks from different sectors which collectively represents the state of the economy. To include a stock in the index it should qualify certain criteria. Once qualified as an index stock, it should continue to qualify on the stated criteria. If it fails to maintain the criteria, the stock gets replaced by another stock which qualifies the prerequisites.

 

Based on the selection procedure the list of stocks is populated. Each stock in the index should be assigned a certain weightage. Weightage in simpler terms define how much importance a certain stock in the index gets compared to the others.

 

 

The Key Takeaways:

 

1. An index acts as a barometer of the whole economy

2. An index going up indicates that the market participants are optimistic

3. An index going down indicates that the market participants are pessimistic

4. There are two main indices in India – The BSE Sensex and NSE’s Nifty

5. Index can be used for a variety of purposes – information, bench marking, trading and hedging.

6. Index trading is probably the most popular use of the index

7. India follows the free float market capitalization method to construct the index

8. There are sector specific indices which convey the sentiment of specific sectors