A stock market index (or stock market indices if there is more than one) is a group of stocks used to measure the performance of a sector, stock market, or economy. A stock index usually consists of a set number of the top stocks of a particular exchange.
As a trader, understanding how to measure stock market indices is important as it helps you assess the performance of a particular stock market, and through that, you can predict the pattern of stock market prices.
Note the change in value over time
The most common way to read an index is to note the changes in its values over time.
In general, the value of a stock market index is based on the value of the individual stocks that make up that index. Because these prices change often, each stock market index is unique and no two are completely alike.
With different stocks and varying calculations, it is worth noting that every new stock market index has different starting values, and should not be measured against each other.
To put it in perspective, if one index goes up 300 points a day while the other goes up only 50, you may think that the first index performed better than the second. However, if the first index was initially 50,000 while the second index started at 500, then the second index had done better in terms of percentage.
With stock market indices, you should focus on the percentage of rise and fall instead of its point value, as a higher percentage gain means a bigger profit, while a higher percentage loss signifies a bigger loss.
Note that most stock market indices do not measure the performance of the entire market but only show the general health of the sector, industry or economy they represent. Therefore, you can find out how each stock contributes to the index by understanding which stocks make up that particular index and how they are weighted.
Look at the weightage of the indices
To recap, there are three types of weighted indices, which are market-capitalisation-weighted, equal-weighted, and price-weighted indices. They are categorised according to how the stocks influence the overall market index.
To properly read stock market indices, you’d need to know how much weight each individual stock would have on the index. There are separate ways of reading and analysing different weighted indices. This part will explore how each weighted index could be read.
Market-capitalisation-weighted indices
Being the most common index weighting, market-capitalisation-weighted indices consider stocks with a larger market capitalisation to have more influence and a bigger weightage on the overall market index. These indices represent what a trader would earn if they purchased stocks of every company in the index.
Let’s look at an example index that consists of Company A, Company B, and Company C. Let’s say these companies have 7,500, 2,000, and 500 stocks respectively, each of their stocks priced at USD10, USD100, and USD500. In this example, Company A would have a lower market capitalisation at USD75,000, followed by Company B at USD200,000, leaving Company C with the highest market capitalisation at USD250,000.
If Company C’s stocks rise, it would have more of an impact on the value and percentage of the index compared to Company A having the same rise in stock prices. In the same way, if Company C’s stocks plummet, the value of this index will be more affected than if it were a huge decline in Company A’s stocks.
Equal-weighted indices
Equal-weighted indices, as their name suggests, are affected equally by every company they consist of.
To find the value of this index, each of these companies’ individual stocks would be multiplied by the weight each company carries (calculated according to the number of companies in the index), and summed up to get the index value.
| Equal-weighted index of Companies A, B, and C | (USD 10 x 33.3%) + (USD 100 x 33.3%) + (USD 500 x 33.3%) |
Looking back at the example above, there are 3 companies, which means each company would share one-third of the weight or 33.3% each. Following this formula, the index value would be USD203.13.
Price-weighted indices
Like market-capitalisation-weighted indices, the value of price-weighted indices depend on the price of each individual stock. The difference is that with these indices, the price of each individual stock determines the percentage of influence it has on the index (with market-capitalisation-weighted indices, the number of stocks the company has also influences the index).
Let’s look at the weightage of each company from the example above if they were price-weighted.
| Weight of Company A |
USD10 / (USD10 + USD100 + USD500) x 100% = 2% |
| Weight of Company B |
USD100 / (USD10 + USD100 + USD500) x 100% = 16% |
| Weight of Company C |
USD500 / (USD10 + USD100 + USD500) x 100% = 82% |
Based on the calculations above, the stocks in Company C would have more influence on the value of the index than in Company A and B.
Therefore, if there is a minor spike in Company C’s stock prices, it would have a bigger effect on the overall stock index compared to a similar spike in Company A’s or B’s. On the other hand, a minor dip in Company C’s stock prices might have a similar effect on the index as a major dip in Company A’s stock prices.
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