Econ Grapher

Stock Market Index

What is a Stock Market Index?
A stock market index, or market index, is a metric designed to capture movement in a certain defined market e.g. top 100 shares by market capitalisation. In this way the index is able to be used as a gauge for how prices are generally moving in a market. Most indexes are calculated on a market cap basis, so another way of looking at it is as the weighted average change in prices, cumulated over time. Thus from looking at a chart of an index you can see how the market is trending. Most long term stock market index charts show a long term upward trend (albeit with some periods of not-so-upward movements). A stock market index can be used for benchmarking, trading signals, as an underlying for ETFs or derivatives, and even as an economic indicator.

How does it relate to Markets?
Indexes are a critical market analysis tool, they allow a quick assessment of what the market is doing. Often when a commentator says something like the US market dropped (e.g. S&P 500), or Chinese stocks jumped x% (e.g. Shanghai Stock Exchange Composite Index), they are referring to an index. And of course various indexes affect each other, for example the US stock market movements will often be mirrored in other markets around the world, so if the Dow Jones is up 3% over night then the ASX All Ordinaries will probably also rise the next day, (and the NZX 50, Nikkei 225, Hang Seng, etc). Indexes can even be somewhat self-predicting sometimes - especially for those who study technical analysis. For example some market analysts will monitor the progress of an index against a 50 or 200 day moving average in order to gauge the trend; they may make decisions based on a crossing of the moving average, as an example. There are also indexes that measure the volatility of a market e.g. the VIX.

Index Calculation/Methodology
Calculation of the individual index can vary significantly, particularly for more innovative indices, and those that track more unique markets and instruments e.g. volatility indexes, house price indexes, strategy indexes (e.g. buy-write options trading strategy index), and even fundamentally weighted or socially weighted indexes. The traditional stock market index is basically calculated like holding a portfolio of stocks. Most of them are weighted by market capitalisation (and usually on a free-float basis i.e. considering the stocks that are effectively on the market vs strategic holdings, majority holders etc). Thus it's really quite simple to create a stock index, just pick a base period e.g. today, and a base amount e.g. 100, then determine the criteria for the index e.g. top 5 stocks, and determine the weighting e.g. market capitalisation. Then simply, as each day passes calculate the market capitalisation weighted (i.e. market cap of stock A divided by total of market cap of all stocks in index) return (i.e. price at end of day 1 divided by price at end of day 0); and multiply this by the previous day's index value. So for example, if the index was 100 yesterday and today the weighted average return is 1% then the new index value will be 101.

Investment Strategy and Instruments
As noted, market indexes can be used as part of informing investment strategy, but they can also become part of strategy execution itself. For example a lot of indexes have ETFs on them (Exchange Traded Funds), which are tradeable units in investment funds that use passive investment strategy (i.e. simply invest in stocks by the same weighting as the index and receive market returns). ETFs can be used for long or short views on the markets, for example in the US there are ETFs which produce a return similar to shorting an index, or going long an index - or even going twice long (so that you gain twice of the upside - and downside). You can also buy and sell options and futures on indexes, and swap interest rate payments for market based returns. 

Sources and further reading:
World Federation of Exchanges - Statistics
About.com - What is a Stock Index?
wikinvest - How stock indices work
Dow Jones Indexes
MSCI
NASDAQ - Stock Market Indices

Graph Library:
Metric - Stock Index

Original Source: http://www.econgrapher.com/encyclopedia-stockindex.html

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