The Stock Markets Index

The Stock Markets Index

7.1 - Overview

a real time summary on the traffic situation how would you got it?

it is unlikely you would check each and every road in the city to find the answer. The wiser thing for you to do would be to quickly check, a few important roads and junctions across the four directions of the city and observe how the traffic is moving. If you observe chaotic conditions then you would simply summarize the traffic situation as chaotic, else traffic can be considered normal.

if I were to ask you how the stock market is moving today, how would you answer my question? 

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.

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.

So essentially identify a few companies to represent the broader markets.

7.2 - The Index

The important companies are pre packaged

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 Nify 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.

CNX Nify 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.

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.

7.3 - Practical uses of the Index

 Information –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.

For example the Nify value on 1st of January 2014 was 6301 and the value as of 24th June 2014 was 7580. This represents a change of 1279 points in the index of 20.3% increase. This simply means that during the time period under consideration, the markets have gone up quite significantly indicating a strong optimistic economic future.

Benchmarking –

Well on the face of it, a 20% return looks great. 

However what if during the same year Nify moved to 7,800 points from 6,000 points generating a return on 30%?

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 -

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.

example - At 10:30 AM the Finance Minister is expected to deliver his budget speech. An hour before the announcement Nify index is at 6,600 points. You expect the budget to be favorable to the nation’s economy. What do you think will happen to the index? Naturally the index will move up. So in order to trade your point of view, you may want to buy the index at 6,600. Afer all, the index is the representation of the broader economy.

index trading is possible through the derivative markets.

Portfolio Hedging –

A typical portfolio contains 10 – 12 stocks which they would have bought from a long term perspective.

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.

7.4 - Index construction methodology

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.

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. For example if ITC Limited has 7.6% weightage on Nify 50 index, then it is as good as saying the that the 7.6% of Nify’s movement can be attributed to ITC.

The obvious question is - How do we assign weights to the stock that make up the Index?

Indian stock exchange follows a method called free float market capitalization.

 larger the market capitalization, higher the weight.

Free float market capitalization is the product of total number of shares outstanding in the market, and the price of the stock.

For example company ABC has a total of 100 shares outstanding in the market, and the stock price is at 50 then the free float market cap of ABC is 100*50 = Rs.5,000 

 

7.5 - Sector specific indices

For example the Bank Nify on NSE represents the mood specific to the banking industry

Key takeaways from this chapter

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 Nify

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