Introducing the financial markets
Trading stock indices
How are major stock indices calculated?
Most major indices are either calculated using a capitalisation-weighted or a price-weighted system.
Capitalisation-weighted system
Used by the majority of stock indices, this system takes the size of each company into account when calculating the value of the index as a whole. So, the more a particular company is worth, the more its share price will affect the index.
You can tell how much a particular company is worth by multiplying its share price by the number of shares issued. This is called its market capitalisation.
The FTSE 100 is calculated using this method. So if, for example, BP is valued at twice the size of Barclays - any change to BP's share price will have twice as large an effect on the FTSE 100 as a similar change for Barclays.
Other indices using this system include the S&P 500, NASDAQ-100, Hang Seng, CAC 40, IBEX 35 and ASX 200.
Price-weighted system
This method is based on the actual share price of the companies in the index, rather than their overall size.
The higher the share price, the more influence that company has on the value of the index. For example, a stock trading at $100 would have five times more clout than one trading at just $20.
The only two major indices that use this system are the Dow Jones Industrial Average and Nikkei 225.
Question
The ABC index is capitalisation-weighted and represents the total value of the following three stocks:- Company A has a share price of £1 with 10 shares issued
- Company B has a share price of £2 with 20 shares issued
- Company C has a share price of £5 with 50 shares issued.
Correct
Incorrect
Value of ABC index= (1 x £10) + (2 x £20) + (5 x £50)
= £10 + £40 + £250
= £300
How do you trade stock indices?
Since indices are effectively just numbers, you can't buy or sell them directly. There's no asset to own and nothing to exchange. Therefore, to trade on the price of an index, you need to choose a product that mirrors its performance. There are several that do this:
Index fund
A specialised investment fund that attempts to replicate the movements of a particular stock index. You can invest in index funds through a fund manager.
Exchange-traded fund (ETF)
A distinct type of index fund that can be traded like a stock on an exchange. Just like stocks, the price of ETFs can change throughout the trading day as they are bought and sold. Currently the largest ETF in the world is the SPDR S&P 500 which, unsurprisingly, tracks the S&P 500.
Derivatives
Financial products that derive their price from the performance of an underlying instrument. For example: futures, options, binaries, spread bets or contracts for difference (CFDs).
Lesson summary
- Capitalisation-weighted indices are calculated based on the size of their component companies
- Price-weighted indices are based on share prices
- Stock indices are just numbers so you cannot trade them directly. You need to use funds or derivatives
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