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What is a Stock Market Index?


A stock market index is a measurement of the value of one section of a specific stock market or the entire stock market. The stock market is an aggregate value arrived by the combination of all the stocks in the market, with an expression of their total values in comparison to a base value on a specific date. Normally, the stock market index should represent the entire stock market by including the values of all the stocks traded in it, so that the investors are able to track the changes in the market over a period of time.

However, most stock markets have their own specific individual multiple indexes within them. These indexes are based on the inclusion of a basket of a set of large stocks from different sectors in the market. An example is the S&P 500, which represents the top 500 American companies by market value. Similarly, the London Market has its own FTSE 100, like the Tokyo market has its Nikkei 225 and the Indian SENSEX with 30 stocks, etc. Further, each stock exchange has its own sector indices, such as banking, real estate, energy, etc. As such, the term stock market index is quite broad and you have to learn quite a lot to understand what a stock market index is.

How to Read Stock Market Index?

A stock market index is an indicator of that particular market or a section of that market. Normally, investors take into account the major indices of the markets as indicative of the market movement. For example, the Dow Jones Average is the average pricing of the top 30 American companies by size. Similarly, the FTSE 100 is a compilation of the top 100 companies in the United Kingdom by size.

However, the indices are usually ‘weighted’ on a specific basis. For example, the 100 stocks in the FTSE 100 of London are based on their market capitalization value. This principle assumes that the larger companies would have higher effect on the market compared to smaller companies. Majority of the stock exchanges follow this principle. On the other hand, certain indices are based on price-weighted approach, such as the Dow Jones Industrial Average, the NYSE ARCA tech 100 Index, Amex Major Market Index, etc. Hence, you should first understand the composition of the type of stocks in an index before proceeding to understand how to read a specific stock market index. The latest approach is known as hybrid weighting, which is a combination of weighting by capitalization and by equal pricing.

Stock Market Index Calculation

Any stock market index is just a number indicating the relative levels of the values or prices of the securities in that particular market index on a given day, with a figure from a base day. This figure would be on a specific date and it would start at 100 or 1,000. The standard calculation of the index is arrived as the value of index on day two by dividing the portfolio value of day two by the portfolio value of day one and multiplying by the index value of day one. This is a highly simplified formula but the daily index value computation is much more complex, taking into account the changes in market capitalization of the constituent stocks in the index, by taking into consideration the offer of dividends, rights offers, etc.

The most popular market index capitalization methods are value weighted or market capitalization weighted, price weighted, and equally weighted which is really un-weighted. The Hong Kong Stock Exchange All-Ordinaries Index and the American Stock Market index include all the stocks in their respective markets and hence, they are equally weighted. However, the FTSE 100, the S&P 500, and the SENSEX 30 comprise of specific number of large stocks included in their indices and the value of these indices vary according to the total value of the market capitalization of all these stocks.

Global Stock Market Index Symbols

Each stock market has its own multiple indices. However, the investors focus on certain major global market index symbols for trading. The major index symbols in the Americas are MerVal (MERV), Bovespa (BVSP), S&P TSX Composite (GSPTSE), 500 Index (GSPC), and IPC (MXX) etc. The main indices of Europe are ATX (ATX), BEL-20 (BFX), CAC 40 (FCHI), DAX (GDAXI), AEX General (AEX.AS), OSE All Share (OSEAX), Stockholm General (OMXSPI), Swiss Market (SSMI), FTSE 100 (FTSE), PX Index (FPXAA.PR), MICEX Index (MICEXINDEXCF.ME), and Athex Composite Share Price Index (GD.AT). The main indices in Asia Pacific region are All Ordinaries (AORD), Shanghai Composite (SSEC), HANG SENG INDEX (HSI), BSE 30 (BSESN), Jakarta Composite (JKSE), KLSE Composite (KLSE), Nikkei 225 (N225), NZSE 50 (NZ50), STRAITS TIMES INDEX (STI), KOSPI Composite Index (KS11), and Taiwan Weighted (TWI). The main index in the Middle East is TA 100 of Tel Aviv.

Apart from these indices, each market has got its own separate indices, such as Dow Jones Composite Average, Industrial Average, Transportation Average, and Utility Average, NYSE COMPOSITE INDEX, NYSE International 100, NYSE TMT, NYSE US 100, and NYSE World Leaders, NASDAQ Bank, NASDAQ Biotechnology, NASDAQ Composite, NASDAQ Computer, NASDAQ Financial 100, NASDAQ Industrial, NASDAQ Insurance, NASDAQ Other Finance, NASDAQ Telecommunication, NASDAQ Transportation, and NASDAQ-100, and S&P 400 MIDCAP INDEX, S&P 500, S&P 600, S&P COMPOSITE 1500 INDEX, and S&P 100INDEX. All of them have their own individual symbols. This represents only the U.S. markets. Each country has its own several indices and appropriate symbols.

How to Read Stock Market Index Chart

Reading charts, especially the stock market index charts, is such a subtle and complex art that it could take years to master this art fully. However, unless you are able to read a chart, you would not be able to decide whether you should risk your money on a specific trade. However, reading stock market index charts would not directly help you in investing in a particular stock. This is due to the fact that the overall index might be moving up but a particular stock might be declining in value.

Hence, reading the stock market index chart would help you only if you plan to invest on a long term basis. You could study and evaluate the movement of the stock market index through its chart over a long period and decide whether the index would go up or down as a whole. If there is going to be a substantial rise or fall in the value of the index over the next few months based on your analysis of past index value movements, then nearly all the stocks in that index would also have proportionate increase or decrease, though there might be minor variations in the individual stock price movements. As such, learning to read the stock market index chart as a whole would help you in analyzing the price charts of individual stocks in a much better manner for better and profitable trading.

Stock Market Index Funds

Stock market index funds are collective investment schemes either by a mutual fund (MF) or an exchange-traded fund (ETF). They are also known as index trackers. The operators of index funds achieve tracking by holding all the securities or stocks in the index, maintaining the same proportion of the stocks in the index. Another alternative is to hold representative securities in an index. Most of the index funds function on computer models with very little human input. The decisions on sale and purchase of the securities are automatic and it is a type of passive investment management.

Most of the investment managers offer index funds. Since the fund management is passive and not active, the fees are usually significantly lower than the fees for normal investment and trading. Additionally, the taxes are also lower for index funds. The most popular index funds are the Nikkei 225, the S&P 500, and the FTSE 100. Index fund managers use different types of indexing methods, such as traditional indexing, synthetic indexing, and enhanced indexing. Enhanced indexing is active management operation, instead of the passive approach of the first two methods. The fund managers use two types of strategies in enhanced indexing. They are

  • Issue selection, lower cost, and yield curve positioning
  • Quality and sector positioning, along with call exposure positioning.

The main advantages of index funds are lower costs, simplicity, lower turnovers, and no style drift. However, the drawbacks are losses due to algorithmic trading, possibility of tracking error from the index, inability to outperform the index targeted, and reduced return when index composition changes.

Why There Is No Straight Line in Stock Market Index?

The stock market index is a composite of several stocks. Since the prices of the stocks do not remain the same but keep fluctuating due to continuous buying and selling, the composite index representing all these stocks also keeps moving up and down. The market index and the stocks are basically driven by two types of traders, the ‘rational’ agents who optimize their individual utility functions and the ‘noise’ traders, who make buying and selling decisions either by imitating others or by looking at recent changes or the market volatility. The interaction between these two types of traders naturally keeps the index continuously moving either up or down.

As such, the stock market index could never be a straight line. If it remains straight, that would mean only one thing that no trading is taking place at all, which is not possible in any stock market. When the stock markets are open, investors constantly buy and sell stocks of their choice. It is true that all the stocks in an index are not traded all the time. The chart line for the stocks not traded could remain straight until the investors begin to trade in them. However, the index being a composite of several stocks, would keep moving, since at least a major portion of the stocks would be trading frequently and there would always be a movement in the index chart.

Conclusion

Trading on stock market indices is a much better option than buying and selling individual stocks. However, retail investors would not be able to trade an index directly. Hence, you should use either a mutual fund or even better, an exchange-traded fund or ETF that has been performing well on a regular basis in the past few years. When you invest your money in ETFs, you would be able to obtain fairly reasonable returns or profits on your investment. Since direct trading on stock market indices is not possible, this is the most ideal method of trading in market indices through investments in ETFs. Recent data clearly show that ETFs have performed at least 11% better than most mutual funds. Hence, the ETFs are much safer investment avenues with chances of higher returns.

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