Stock market indices (or stock indices) measure the value of a specific part of the stock market. The stock indexes group a series of securities of different companies to be able to negotiate with them as if they were a single financial instrument. Therefore, the indices capture the performance of those titles in ONE figure.

Stock indices are calculated from the prices of the selected securities and are usually weighted. It is a tool that investors use to describe the stock market and compare different market parts. When investors refer to “market” behavior, they are referring to the results of a stock index.

Trading with stock indices

Stock indices are nothing more than a mathematical construction to measure the performance of markets. You cannot invest in them directly, that is, investors cannot own an index directly as is the case with stocks.

Instead, the investment in stock indexes is made through traded funds on the stock exchange (EFT) that replicate the behavior of the indices or through derivative instruments such as option and futures contracts.

Stock index futures contracts are the instruments with which we operate with our broker. They are based on the underlying price of the index and fluctuate in line with it.

The first ETF to replicate an index was the S&P 500 (SPDR). It was created to reflect the behavior of the 500 largest US companies. UU. Currently, there are hundreds of ETFs and futures contracts that replicate different groups of securities.

Types of stock indices

Stock indices can be categorized in many ways. The “global” or “global” indices are made up of different companies regardless of where they are located or listed.

The “national” indices represent the results of the stock market in a given country and, therefore, reflect the mood of investors regarding the state of their economy. The most commonly traded national indices are composed of the titles of the main companies listed on the country’s stock exchanges. These include the US S&P 500, the Japanese Nikkei 225 and the FTSE 100 in the United Kingdom.

The stock indexes also represent the results of companies in wider geographic regions.

The DJ Euro Stoxx 50 is made up of the titles of 50 first-order companies based solely in the Eurozone. The MSCI Emerging Markets Index is made up of securities from emerging economies only such as Brazil, Mexico and South Africa.

Finally, there are exclusive indexes linked to certain industrial sectors. For example, NASDAQ 100 consists mainly of companies in the technological field and completely omits financial companies. The point is that there are hundreds of different indexes that measure the performance of securities in different sectors and areas.

However, most of the operators concentrate on the national indices that we have mentioned before.

Weighting types

Each title included in an index has a certain level of weight or importance. When no weighting method is used, we speak of an “equal weighted index”, since all companies have the same level of importance whether they are large or small.

However, this type of method is unusual and the most popular indices apply a certain type of weighting. Below we will briefly present the two most frequent types of weighting methods used.

Weighting by price

Price-weighted indexes are those in which each title is weighted according to its price only, that is, the price of the securities is the only thing that is taken into account when weighting companies in the index.

Therefore, a security that is traded at $ 100 (company A) has a weight in the index total 5 times higher than that of another that is traded at $ 20 (company B). This implies that a fluctuation in the price of the securities of company A would have a much greater impact on the index than one on the shares of company B. Some examples of price-weighted indexes include the Dow Jones 30 and the Nikkei 225.

Weighting by capitalization

One of the drawbacks of the price weighting method is that it does not take into account the total size and market value of the companies. This method weighs companies based solely on the total market value of all their shares, that is, the price of their shares divided by the number of outstanding shares.

In our previous example, company A would have a greater weight in the index because the price of its shares is 5 times higher than that of company B according to the price weighting model. However, the true value of a company is not only reflected in the price of its shares, and company A could be smaller than B.

For example, if company A only has 100,000 shares outstanding, its market capitalization will be 100 million dollars. But if Company B has 1 million shares outstanding, its market capitalization will be 20 million dollars.

Thus, according to an index weighted by capitalization, company B would have twice the weight of company A.

Capitalization weighted indices are also known as market value weighted indices. The capitalized weighted indices are usually the most popular and among them are the S&P 500, the FTSE 100, the CAC 40 and the DAX 30.

What makes the price of a stock index fluctuate?

Since stock indexes can be composed of any type of securities, the factors that affect their prices are very varied. Large national stock indices such as the US S&P 500 are greatly influenced by macroeconomic factors in the economy of that country, as well as by microeconomic factors related to the companies that comprise it.

Therefore, as operators, we must bear in mind the results and profitability of the main companies that make up the indices, as well as the economic climate of the country in question. Some key economic indicators that influence indices include, among others:

  • Inflation
  • Interest rates
  • Employment levels
  • Price of energy and precious metals
  • Exchange rates
  • Policies and political decisions
  • Monetary and fiscal policy

Most of the stock indexes and ETFs replicate the behavior of the securities of a certain sector of the economy such as technology, financial services, real estate or health. If we operate with these types of instruments, we have to know the current state of the economy and the profitability of the sector.

In the next six articles we will analyze in greater depth some of the most traded stock indices, their composition and how they are calculated, including the  Dow Jones Industrial Average 30 (US), Standard & Poor’s 500 (US), FTSE 100 (United Kingdom), DAX 30 (Germany), CAC 40 (France) and Nikkei 225 (Japan).