7.1 - Overview

How would you give me a current summary of traffic conditions if I asked you?

There may be many roads and junctions in your city. It is unlikely that you could check all of them. It is better to check the main roads and intersections in the city's four directions to see how traffic is moving. You can simply describe chaotic traffic conditions on these roads as chaos, or you could consider it normal.

These were the most important roads and junctions you could track, to sum up the traffic situation in the city.

Parallels aside, I would like to ask you how the stock exchange is doing today. The BSE has approximately 5,000 companies and the National Stock Exchange has about 2,000. The detailed answer will then be provided.

Instead, you should only look at a handful of important companies in key industries. If the majority of these companies move up, then markets are up. If the majority are falling, markets are down. And if markets are in a mixed trend you'd say markets have gone sideways.

You will need to identify a few companies that represent the larger markets. If someone asked you how the markets are doing you would simply check the trend of the selected stocks, then answer. The stock market index is made up of the companies you identified.
 

7.2 The Index

To get an overview of the market, you don't have to track each company individually. These companies are pre-packaged, and they are continuously monitored to provide you with this information. The 'Market Index' is a pre-packaged market information tool.

India has two major market indices. These are theS&P BSE SensexRepresents the Bombay stock markets X NiftyRepresents the National Stock Exchange

S&P stands for Standard and Poor's, which is a global credit rating agency. S&P is the technical expert in the construction of the index, which they licensed to the BSE. The S&P label is also attached to the index.

CNX Nifty is a collection of the most traded stocks on the National Stock Exchange. India Index Services & Products Limited, a joint venture between CRISIL and the National Stock Exchange, maintains it. In reality, the term CNX stands for CRISIL/NSE.

A perfect index provides minute-by-minute information about the market participants' future expectations. The changes in the Index's movements reflect market participants' changing expectations. The index rises when market participants believe the future is better. If the market participants see the future as negative, the index will drop.
 

7.3 - Practical Uses of the Index

Below are some examples of Index's practical applications.

The information- The index represents the market trend over a given time period. The index represents the economic state of the country. An up-trending stock market index indicates that people are optimistic about the future. People are also pessimistic about their future if the stock market index goes down.

The Nifty value was 6301 on January 1, 2014, and 7580 as of June 24, 2014. This is a 1279 point change in the index, which represents a 20.3% rise. This means that the market has risen significantly in the period under review, which indicates a bright economic future.

You can set the time period for calculating an index for any length of duration. The Index at 9:30 AM on 25 June 2014 was 7,583, but it moved to 7,565 an hour later. This period saw a drop in the Index of 18 points, which indicates that market participants aren't too excited.

Benchmarking-A yardstick is needed to determine the performance of any trading or investing activity. Let's say that you have invested Rs.100,000.0 and received Rs.20,000 in return over the past year. This would make your total capital Rs.120,000/. What do you think your performance was? A 20% return seems great on the surface. What if Nifty's value rose to 7,800 points, from 6,000? Would that be a 30% return?

It may suddenly seem that you are underperforming the market. Without the Index, it's impossible to know how you did in the stock market. The index is necessary to measure the performance of investors or traders. Market participants usually aim to outperform the Index.
 

the trading index can be traded. The index is traded by a majority of traders on the market. They make a wider call on the economy and general state of affairs, then translate it into a trade.

Imagine this scenario. The Finance Minister will deliver his budget speech at 10:30 AM. The Nifty index was at 6,600 points an hour before the announcement. The budget should be favorable to the economy of the country. What do you expect to happen to the index? The index will naturally move up. You may be able to trade your points of view by buying the index at 6,600. The index represents the wider economy.

As per your expectations, the budget is satisfactory and the index rises to 6,900. Now you can book your profits and exit the trade with a profit of 300 points. These trades are possible via what is called the "Derivative" segment of the markets. Although it is too early to look into derivatives, index trading is still possible through the derivative market.
Portfolio Hedging-An investor usually builds a portfolio of securities. A typical portfolio includes 10-12 stocks that they would have purchased if they had a longer-term view. The stocks are held with a long-term perspective. However, investors could see a prolonged adverse market movement (2008) which could potentially deplete the portfolio's capital. Investors can use the index as a hedge to protect their portfolio in such an instance. This topic will be covered in the risk management module.
 

7.4 - Index construction method

If you want to become an index trader, it is essential to understand how the index is built/calculated. The Index, which is made up of stocks from various sectors and collectively represents the economy's state, is what we have discussed. A stock must meet certain criteria to be included in the index. It must continue to meet the criteria once it is qualified as an index stock. It is replaced by another stock that meets the prerequisites if it fails to meet the criteria.

The stock list is created based on the selection process. Every stock in the index should have a weightage. Simpler terms for weightage are how important stock is compared to others in an index. If ITC Limited's Nifty 50 index is 7.6%, then this would mean that 7.6% of Nifty's movement can be attributed to ITC Limited.

It is obvious that we need to ask ourselves how do we assign weights for the stocks that make up the Index.

There are many ways of assigning weights. However, the Indian stock market follows one. Method of free-float capitalization company's market capitalization is used to determine the weight. The larger the market capitalization the greater the weight.

The capitalization of the free-floating market is the sum of the total market shares and the stock price.

ABC, for example, has 100 shares in the market. If the stock price is 50, then ABC's free-float market capital is 100*50 = Rs. 5,000.

The following 50 stocks were in Nifty at the time of writing this chapter according to their weight:

As you can see ITC Ltd is the most weighted. This means that the Nifty index is more sensitive to price fluctuations in ITC Ltd than it is to changes in DLF Ltd.

7.5 - Sector-specific Indicators

Nifty and Sensex represent the broader markets. However, some indices are specific to certain sectors. These are the sectoral indexes. The Bank Nifty (NSE) represents the mood of the banking industry. NSE's CNX IT index represents the behavior of all IT stocks on the stock market. Both NSE and BSE have sector-specific indices. These indices can be constructed and maintained in the same way as other major indices.

To Summarize

1. An index is a barometer for the entire economy.
2. A rising index indicates optimism among market participants.
3. A falling index indicates that market participants are pessimistic.
4. India has two major indices: the BSE Sensex (index) and NSE's Nifty (index).
5. An index can be used to provide information, benchmarking, and trading, as well as for hedge-hedging purposes.
6. Index trading is the most common use of the index.
7. India uses the free-float capitalization method to build the index.
8. There are also sector-specific indicators that convey the sentiments of certain sectors.