We will see that some stocks had moved in the opposite direction. Here, when we talk about the movement of the ‘market’ it is the fluctuation of the indices.

Certain stocks are selected from among the stocks listed on the exchange and grouped to form an index. The classification could be based on the sectors to which industries the companies belong, the company size or market capitalization. For example, the BSE Sensex index comprises of 30 stocks. Similarly, the BSE 500 index comprises of 500 stocks, and NSE Nifty is an index comprising of 50 stocks.

An index indicates the changes in the market, as the values of all the stocks in the group are taken to calculate the value of an index. Any change in the price of the individual stocks leads to a change in the index value.

Here are some of the important indices in India are:

• BSE Sensex and NSE Nifty which are Benchmark indices.

• Sectorial indices like BSE Bankex and CNX IT.

• Indices based on Market capitalization such as the BSE Small-cap and BSE Midcap.

• Broad-market indices such as BSE 100 and BSE 500.

Uses of Stock Indices.

As there are thousands of companies listed on the Stock exchange, it is very difficult to differentiate between all of them and choose the stock to buy. It is here the indices come into the picture. Classification of shares into indices is based on their main characteristics such as the size of the company, sector, or the type of industry they belong to.

Indices are supposed to represent the entire market or a certain segment of the market. BSE Sensex and the NSE Nifty are the benchmark indices in India, and they represent the performance of the overall market. In the same way, an index consisting of IT stocks is supposed to represent all stocks of companies from the industry.

Indices make it easy for an investor to compare performance, and can be used as a benchmark to compare with the Sensex or Nifty. So to find out if a particular stock has outperformed the market, we have to just compare with the price trends of the index and that stock. The index can also be used for comparing a set of stocks against a benchmark or another index. For example, the benchmark Sensex may climb 200 points on any day, but this rally may not reflect in a certain segment of stocks like IT. This fall in the value of the index that represents IT stocks can be used for comparing rather than particular stocks and help investors to easily identify market trends.

Investor sentiment plays an important role in stock market fluctuations. The reason is that a demand for a stock can be seen if the sentiment is positive, which leads to an increase in prices. Gauging investor sentiment correctly is very difficult. Indices help in reflecting the mood of the investor for the overall market sector-wise and also across company sizes. By comparing an index with a benchmark to see if it has underperformed or outperformed, will reflect investor sentiment.

By investing in a portfolio of stocks that closely resembles an index helps investors to cut down the cost of research and stock selection. As they rely on the index to select stocks, the returns on the portfolio will match that of the index. If the Sensex gives 12% returns in a month, the portfolio that constitutes the Sensex is likely to give the same amount of returns. Mutual funds and exchange-traded funds (ETFs) are constructed construct using Indices.

HOW ARE STOCK INDICES FORMED?

The stocks comprising the index are based on the type of industry, company size, market capitalization, etc. The value of the index is calculated after the stocks are selected. This may be a simple average of the prices of the stocks included. In India, the free-float market capitalization is generally used instead of the prices, to arrive at the value of any index.

Price-weighted and market capitalization-weighted index are the two most common ones.

What is the stock weightage?

As each stock has a different price, even a very small percentage change in a particular stock will not be equal to a similar change in the price of another stock. For this reason, the index value cannot be just the sum of all the stocks. This is where the concept of stock weightage comes into the picture. The weightage of every stock in an index depends on its price and market capitalization. This is the amount of impact that a change in the price of a stock has on the index value.

Market-cap weightage.

In the free-float market capitalization, the total market value of a company’s stock is calculated by multiplying the current market share price of a stock with the total number of stocks publicly available for trading. It takes into consideration both the size and the price of the stock. An index using market-cap weightage, the weightage of the stock is given based on their market capitalization when compared to the total market capitalization of the index. To give an example, if a particular stock 'A' has a market capitalization of Rupees 20,000 whereas the index of which it is part has a market cap of Rupees 1,00,000, then the weightage of the stock will be 20% and another stock with a market-cap of Rupees 40,000, will have a weightage of 40%.

Although it is a marginal change, the market capitalization keeps changing every day as the price of the stocks fluctuates and the weightage of the stock also keeps fluctuating every day. The importance is given to companies with a higher market capitalization in the market capitalization-weightage method,

Price weightage.

In a price-weighted index, the value of the index is calculated based on the company’s stock price, and not market capitalization. Stocks that are higher in price have greater weightage in the index. In Japan, the Nikkei 225 and The Dow Jones Industrial Average in the US are examples.