Stock indices are financial markets based on stocks. Their value is calculated using the prices of the underlying individual stocks. The method used may not be the most direct. The Nasdaq 100, the S&P 500, the British FTSE 100, and the French CAC 40, are all indices.
- Two general methods are used to calculate the value of a stock index, the direct and indirect methods.
- There are several factors used and considered when the indexes are calculated.
- Knowing how an index is calculated can help you improve your trading.
Direct and Indirect Stock Index Calculation
A stock index might consist of 25 individual stocks. Their prices could be added together (e.g., price of stock #1 + price of stock #2 + ... = price of a stock index). This is how a direct stock index price calculation works.
What's more common is the indirect method of index price calculation. In this case, the prices of the 25 underlying stocks are averaged. The result is multiplied by the average trading volume of each of the underlying individual stocks (i.e., the value of each stock's trading). They are then added together to create the trading turnover weighted price of the stock index. In this instance, the index is weighted by average trading turnover.
The more popular indexes are weighted by market capacity and float-adjusted to correct for stocks held by corporations.
Some Stocks Are Much More Equal Than Others
One key difference between a directly calculated stock index and an indirectly calculated stock index is the weight given to each underlying individual stock.
For a directly calculated stock index, the underlying individual stocks are valued the same. They are weighted so that one stock is as important as each of the other stocks.
For an indirectly calculated stock index, the underlying individual stocks are valued unequally. Some of the stocks are more important than others.
The underlying individual stocks deemed more important will cause more price movement of the stock index than the underlying individual stocks carrying less weight.
For example, an underlying individual stock with twice the trading turnover of another underlying individual stock will have twice the effect on the price movement if the stock index is weighted by trading turnover.
While every one-point increase in the price of the more important underlying individual stock might cause the price of the stock index to increase by one point, every one-point increase in the price of the less important underlying individual stock might cause the price of the stock index to increase by only half a point (or even less).
How Stock Index Calculations Can Improve Your Trading
Learning how a stock index is calculated, or more specifically knowing which underlying individual stocks are the most important for the calculation of the stock index, can be useful for trading the stock index itself and for trading the underlying individual stocks themselves.
A trader who wants to make a long trade on XYZ stock index could analyze the underlying individual stocks that are considered important for XYZ stock index. This helps to determine if they are in agreement with the long trade.
If the key underlying individual stocks were in agreement with the long trade (i.e., if the underlying individual stocks were also bullish), then that would be a very good confirmation of the long trade. If the important underlying stocks were out of line with the long trade (i.e., if the underlying individual stocks were bearish), then that could be a warning not to make the long trade.
How Is XYZ Stock Index Calculated?
Each stock index has its own calculation. It can range from relatively straightforward to rather complex—as shown in the previous examples. You can usually find the method of calculation used for a particular stock index by going to its website.
However, note this is not always the case.