Indices are financial instruments designed to track the overall price performance of a basket of stocks. An index uses a statistical measure of change to effectively reflect the overall performance of the selected stocks.
Indices can be excellent for trading because they provide exposure to general market movements and internal diversification to reduce risk.
For example, the US S&P 500 Index is a well-known and popular index. It is designed to track the performance of 500 of the largest companies listed on US stock exchanges. A rising price in the S&P 500 Index is a clear indication that the overall stock market is bullish (experiencing an upward trend), while a falling price indicates that the market is generally bearish (facing a downward trend).
Indices serve as a benchmark for stock market performance across different regions, sectors, or any other relevant location based on their composition. They are popular with traders who want the simplicity of taking a broad position on the markets without having to manage numerous individual positions.
For example, if you are bullish on the UK market, you can simply buy one of the major UK indices, such as the FTSE 100. In addition to their simplicity, indices also offer other advantages, such as:
Effective diversification, broad market exposure, consistent price movements, and high liquidity.
How are indicators compiled?
The index is determined by its components, or rather by the stocks that comprise it. Indices can be broad and contain a wide range of stocks in a sector, or they can be location-specific. The different types of indicators include:
Global Indicators
Global stock indices are made up of stocks from around the world. An example is the Dow Jones Global Titans 50, which tracks 50 of the largest and most actively traded stocks on the New York Stock Exchange, the Amman Stock Exchange, Nasdaq, Euronext, the London Stock Exchange, and the Tokyo Stock Exchange.
Regional Indicators
Regional indices are made up of stocks from a specific region, such as South America, Europe, or Asia. The Euro STOXX 50 is an example: it measures the performance of 50 stocks spread across 11 eurozone countries.
National indices
National indices consist of stocks from a single country. The ASX100 is an example, covering the overall performance of 100 of the largest listed stocks in Australia.
Sector indices
These indices track the performance of selected stocks within a specific sector or industry. Some key sectors include:
Energy, technology, finance, industrials, and healthcare
Sectors can be as broad as healthcare or as specialized as biotechnology. The Global Cannabis Giants Index (BGCANG Index), developed to track the stock market performance of the 20 largest listed companies with exposure to the cannabis industry, is an example.
Stock market indices are very popular, although stocks are not the only financial assets that can be indexed. There are also indicators available for assets such as:
REITs, bonds, commodities, hedge funds, and more.
The very idea of indices is to provide the trader with comprehensive exposure to a broad or narrow sector of the economy or market.
How are the indicators calculated?
Indexes are compiled to ensure liquidity, ease of replication, and maximum market exposure. There are always specific criteria for determining whether stocks are included or excluded, as well as their weighting in the index. Weighting refers to a particular stock’s contribution to the overall index.
In most cases, periodic rebalancing will also be performed to ensure the index remains consistent with its objectives. A special mathematical divisor or multiplier may also be applied to ensure that certain investment objectives of an index are met.
The price of an index depends on its constituents. There are generally two ways to determine a stock’s weight in indices:
1. Market Capitalization
A market capitalization-weighted index is designed to give a higher weighting to stocks with a larger market capitalization. For example, Stock A, with a market capitalization of $10 billion, would have a higher weight in the index than Stock B, with a market capitalization of $3 billion.
Most major indicators are compiled this way. However, there may be some differences, such as indices that consider all outstanding shares issued on the market (free-float indices) and full-market indices that consider both active and inactive shares. Examples of capitalization-weighted indices include the S&P 500, the TSX, and the CAC40.
2. Price
A price-weighted index is designed so that stocks with higher prices are weighted more heavily than stocks with lower prices, regardless of market capitalization. A common example of a price-weighted index is the Dow Jones Industrial Average (DJIA).
There are also other methods used to compile indexes, such as:
Equal Weighting – An equal-weighted index gives equal weight to all stock components. Therefore, if the index has 10 components, each stock has a 10% weight.
Fundamental Weighting – A fundamentally weighted index gives higher weights to components with better fundamentals. For example, a stock may have a higher weight in a fundamentally weighted index if it exhibits better performance indicators such as price-to-earnings ratio, profit factor, and dividend payments.